As conditions in the corporate bond market improve—limiting potential gains for bottom-fishing investors—private equity firms and Wall Street banks are seizing opportunities in the $28 billion market for distressed municipal bonds. The investors are using a strategy borrowed from the corporate bond world known as "loan to own," which involves buying debt to gain control of revenue-producing municipal projects.
Citigroup (C) took over St. Louis's Renaissance Grand Hotel & Suites in December when it purchased revenue bonds backed by the 1,000-room hotel after lenders foreclosed. Fundamental Advisors, a New York private equity firm, took control of the Memphis Redbirds minor league baseball franchise and the team's AutoZone Park after buying its tax-exempt debt.
The bonds, some of which changed hands for 53 cents on the dollar, may herald a new outlet for investors in distressed debt. "Assets such as highways, water treatment plants, sports stadiums, racetracks, parking facilities, or parks may be very attractive," says Deryck Palmer, co-chairman of financial restructuring at law firm Cadwalader, Wickersham & Taft in New York.
Investment firms including Goldman Sachs (GS) have discussed raising funds with investors that would target assets backed by distressed revenue bonds, according to people familiar with the talks. Ultimately, the goal is to profit by selling the properties when market conditions improve.
The St. Louis purchase gave Citigroup control of the trustee that oversees the hotel after the bank bought a majority stake in $98 million of revenue bonds backed by Renaissance from Nuveen Asset Management, according to two people with knowledge of the deal who asked not to be identified. "Our goal is to reach the best outcome for the bondholders and for St. Louis," Citigroup spokesman Alexander Samuelson says.
The default rate on speculative-grade corporate debt—also known as leveraged loans—has fallen as the U.S. economy has strengthened, sending prices of those bonds higher. That means investors no longer expect such loans to produce the strong returns posted over the past few years, according to Debtwire's North American Distressed Debt Market Outlook 2011.
In the muni bond market, defaults totaled $18.6 billion from 2008 to 2010, exceeding the previous eight years' combined total of $15.3 billion, according to Richard Lehmann, publisher of Distressed Debt Securities Newsletter. The issuing of revenue bonds, which are backed by specific projects such as a toll road, a bridge, or a hotel, peaked in 2007 at $317 billion, more than double the amount in 2000, according to data compiled by Bloomberg. These bonds make up 80 percent of the municipal market's distressed securities, or $22.3 billion, according to Bloomberg data.
A fund managed by Goldman Sachs holds revenue bonds backed by Branson Airport, a privately owned $155 million facility that opened in May 2009 in the Ozark Mountains region near Branson, Mo. Now, Branson Airport, led by former Greenwich Capital Markets executive Stephen Peet, is in talks with the Goldman fund and other bondholders on restructuring the debt, according to a person familiar with the project.
Branson's airport lost $9.8 million in the first three quarters of 2010, according to its filings. If an agreement can't be reached, creditors could seek control of the facility, the person says. Jeff Bourk, the airport's executive director, and Peet didn't return calls and e-mails seeking comment. Goldman Sachs spokeswoman Andrea Raphael declined to comment.
Fundamental Advisors purchased tax-exempt bonds last year backed by both the Memphis Redbirds and the team's AutoZone Park, obtaining financial control of the 14,000-seat stadium as well as the team, a Triple-A affiliate of the St. Louis Cardinals. "There are certainly opportunities in distressed projects financed with municipal debt for investors who understand this nuanced, opaque market," says Laurence Gottlieb, chief executive officer of Fundamental Advisors.
The Memphis Redbirds Baseball Foundation, which spent $80 million building the stadium before defaulting in 2009, has operated under forbearance agreements with creditors since missing payments on its $72 million tax-exempt bond issue, according to John Pontius, the foundation's treasurer. The Redbirds' relationship with their original bondholders, a group of asset managers and regional banks, became "adversarial" after the team failed to carry out its business plan and operations suffered as it struggled to service debt, Pontius says. "We owed so much to the bondholders that we didn't have enough money to run the team properly," says Pontius, who has served as volunteer treasurer of the foundation since 2005. "We had a database of potential customers who we weren't calling and repairs we weren't making. Our new bondholders see this as a partnership and are making reasonable judgments concerning the working-capital needs of the business."
The bottom line: With corporate bonds rallying, bargain-hunting investors are turning to the muni market, buying debt and taking over properties.