Private Equity Loses to Junk as Dealmaking Wanes: Credit Markets

Carlyle Group CEO Glenn Youngkin
Glenn Youngkin, chief executive officer of the Carlyle Group. Carlyle said in February it finished acquiring businesses overseeing 2.1 billion euros ($2.6 billion) of CLOs from Highland Capital Management LP. Photographer: Francis Specker/Bloomberg

Private-equity firms from Blackstone Group LP to Carlyle Group LP that fueled an expansion in the market for junk bonds and loans during the leveraged buyout boom are now loading up on that debt as takeovers dwindle.

Blackstone’s credit business, the only unit at the world’s biggest private-equity company to boost profit in the second quarter, increased its assets by 50 percent in the 12 months ended June 30, according to a regulatory filing last week. Carlyle’s global-market strategies unit, which is mostly invested in debt, has almost tripled its assets since March 2010 to become the firm’s fastest growing business.

LBO firms are expanding purchases of speculative-grade bonds and loans as dealers cut their corporate debt holdings by 84 percent since 2007 and investors shifted $41.4 billion this year into funds that buy the assets. KKR & Co. plans to open two debt funds for individuals to help bolster its offerings beyond leveraged-buyout funds after the value of private-equity deals in the second quarter fell 36 percent from a year earlier.

“If you can’t put equity into a new deal, you can buy the debt of an old deal,” said Jason New, head of distressed investing at New York-based Blackstone’s GSO Capital unit, which oversees $50.5 billion. “We have the added advantage of a lot of institutional knowledge of these companies.”

Junk Divergence

Private-equity firms are betting on credit even as a global rush of cash into junk-rated debt in the U.S. pushes yields on the bonds to within 0.5 percentage point of the record low, according to Bank of America Merrill Lynch index data. The U.S. market for high-yield, high-risk, or junk bonds, rated below Baa3 by Moody’s Investors Service and lower than BBB- at Standard & Poor’s, has expanded to $1.01 trillion from $634.9 billion three years ago.

The managers are seizing on growing demand for higher-yielding securities that has led to returns of 8.46 percent this year for dollar-denominated junk bonds, Bank of America Merrill Lynch index data show. They’re also seeking to take advantage of a divergence in the market where bond buyers such as exchange-traded funds favor the biggest, most actively traded securities over debt that’s older, smaller and more difficult to trade.

The biggest and newest securities with the lowest ratings have climbed an average 6 cents on the dollar this year, almost double that of debt from smaller and older issues, according to Barclays Plc data.

Bonds rated CCC, smaller than $250 million and issued more than 18 months ago were trading at 91.6 cents on the dollar as of July 19, up from 88.6 cents at year-end, Barclays data show. Issues with the same ratings, greater than $500 million and sold in the past 18 months traded at 98.3 cents, up from 92.3 cents.

‘Very Attractive’

“This dynamic creates an opportunity for fundamental credit investors like KKR to earn very attractive risk-adjusted returns by taking on incremental credit and liquidity risk,” KKR said in a July 18 regulatory filing.

Average yields on junk bonds in the U.S. of 7.72 percent, up from last year’s low of 7.19 percent on May 19, 2011, are helping to make up for a dearth of deals in the companies’ traditional profit center.

The value of private-equity deals announced worldwide in the second quarter fell 36 percent to $102 billion from a year earlier, according to data compiled by Bloomberg.

About $913 billion in private-equity deals were announced in the three years after Lehman Brothers Holdings Inc. filed for bankruptcy in September 2008 and triggered a credit-market seizure, data compiled by Bloomberg show.

‘Flip Side’

That’s less than half of the $2.38 trillion announced in the three years before the crisis, when debt-funded buyouts of companies from Energy Future Holdings Corp., the former TXU Corp., to First Data Corp. spawned leveraged loan offerings that more than doubled the market in three years.

Leveraged loans outstanding soared to as much as $596 billion by the end of 2008, from $247.8 billion in 2005, according to data from S&P’s Capital IQ Leveraged Commentary & Data. About $524 billion of the debt was outstanding as of July 13, the data show.

“Investing in sub-investment-grade corporate credit for private-equity firms is the flip side of the same coin that they’ve always been involved with,” said New of GSO Capital, which has the world’s largest collateralized loan obligation business with $25 billion under management. “It’s a pretty natural extension of what they’ve always done in part because they’re so familiar with credit.”

‘Competitive Edge’

Founded in 2005, GSO is in a “big growth phase,” its head, Bennett Goodman, said in a Bloomberg Television interview in May. Profit rose 31 percent to $54.7 million, while its assets increased to $50.5 billion from $33.79 billion in June 2011.

Carlyle’s global-market strategies group is the Washington-based firm’s fastest growing business, Chief Operating Officer Glenn Youngkin said in a June 12 call with investors.

It increased assets to $28 billion as of March 31 from $10 billion in March 2010 and recorded a 3 percent second-quarter gain for its so-called carry funds, which include distressed, mezzanine and energy mezzanine strategies, according to a preliminary statement on July 9. That’s the biggest increase among the firm’s carry funds for the period.

“We’re looking to create strategies where we think we have a competitive edge in the formulation and execution over the long term,” Mitch Petrick, who heads Global Market Strategies, said in a telephone interview.

Highland Capital

Carlyle said in February it finished acquiring businesses overseeing 2.1 billion euros ($2.6 billion) of CLOs from Highland Capital Management LP. Issuance of CLOs, a type of collateralized debt obligation that pool high-yield loans and slice them into securities of varying risk and return, has increased this year along with the price of the underlying debt.

The S&P/LSTA U.S. Leveraged Loan 100 Index has climbed for seven straight weeks, rising 0.2 cent last week to 94.29 cents on the dollar, the highest since May 15. The measure, which tracks the 100 largest dollar-denominated first-lien leveraged loans, has climbed from 91.8 on June 5, the lowest since Jan. 6.

New York-based KKR, run by Henry Kravis and George Roberts, plans to open two debt funds for individual investors called the KKR Alternative Corporate Opportunities Fund and the KKR Alternative High Yield Fund, it said in filings. Both funds will be managed by KKR Asset Management, the firm’s San Francisco-based unit focused on public investments.

‘Third Inning’

Thomas H. Lee’s THL Credit acquired a $2.5 billion debt manager that oversees high-yield bonds, loans and CLOs from McDonnell Investment Management LLC, it said in a July 11 statement. The unit also manages a business development corporation, buys subordinated debt and equities from companies with annual revenues between $25 million and $500 million. It now oversees $2.8 billion of assets, according to its website.

“We’re in maybe the third inning of this fusion of credit and private equity,” said James Hunt, chief executive officer and chief investment officer of THL Credit Advisors LLC, the Boston-based debt unit of Thomas H. Lee, in a telephone interview earlier this month.

Flows into high-yield bond funds total $39.4 billion this year, up from $13.94 billion in the same period of 2011 and $8.3 billion for all of last year, according to EPFR Global data. Inflows into floating-rate funds, including leveraged loans, have totaled $1.94 billion following $5.93 billion in all of 2011.

At the same time, the 21 primary dealers that trade directly with the Federal Reserve reduced their corporate bond holdings to a record low of $37.5 billion as of July 11, a 20 percent decline from the end of 2012 and down from a peak of $235 billion in 2007, Fed data compiled by Bloomberg show.

Spreads Tighten

“We have more exposure to sub-investment-grade debt than all of Wall Street combined on any given day,” said GSO Capital’s New. “The investment banks have dramatically reduced their high-yield and leveraged-loan inventory.”

Elsewhere in credit markets, the cost to protect against a default by Canada’s Nexen Inc. fell to the lowest in almost a year and its bonds surged after Cnooc Ltd. agreed to buy the oil producer for $15.1 billion. NRG Energy Inc., the power generator acquiring GenOn Energy Inc., obtained a $1.6 billion bridge loan to back bond purchases or exchanges of outstanding GenOn notes. A benchmark gauge of U.S. corporate credit risk rose for a second day.

Credit Swaps

The Markit CDX North America Investment-Grade index, which investors use to hedge against losses or to speculate on creditworthiness, increased 2.5 basis points to a mid-price of 113.8 basis points as of 12:13 p.m. in New York, according to prices compiled by Bloomberg.

In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings added 6.4 to 175.4.

The indexes, which are trading at the highest since June 28, typically rise as investor confidence deteriorates and fall as it improves. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Credit swaps tied to Nexen declined 86.7 basis points to a mid-price of 140.3 basis points, down from 227 basis points on July 20, according to data provider CMA, which is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the privately negotiated market. That’s about the lowest since the contracts closed at 139 basis points on Aug. 4, Bloomberg data show.

Nexen Bonds

Nexen’s $1.25 billion of 6.4 percent bonds maturing in 2037 climbed as much as 14.8 cents from last week to a record 126.9 cents on the dollar, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The bonds traded at 123.9 cents as of 11:20 a.m. in New York. The yield fell to 4.75 percent, or 225.6 basis points more than similar-maturity Treasuries, compared with a 296 basis-point spread on July 20.

Credit Suisse Group AG and Morgan Stanley are providing NRG’s loan, the Princeton, New Jersey-based company said today in a regulatory filing. The bridge loan would support tender offers for Houston-based GenOn bonds maturing in 2014, 2017, 2018 and 2020, according to the filing.

NRG’s $1.7 billion stock purchase of GenOn would create the largest U.S. independent electricity generator. The transaction is expected to close in the first quarter of 2013, the companies said in a joint statement yesterday. Bridge facilities are short-term loans that usually mature in one year and are often used as backstops to bond offerings or longer-dated bank debt.

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