The public debt that has accrued during the global financial crisis (GFC) and throughout the pandemic is a worldwide discussion topic among experts. The most radical have demanded that central banks, who are monetizing government debt as part of fiscal quantitative easing, completely erase their holdings. Contemporary monetary theorists assert that increasing national debt is unimportant, while their critics argue that a US default is unavoidable. Others extol the virtues of converting that inventory of debt into permanent sovereign bonds in a less dramatic manner. In order to achieve it, France has placed its “corvette” in a special-purpose truck.
The State of Things
Governments always stretched thin may choose the “perpetuity” option, but the private industry has shown how to proceed. The structures of corporate loans were tight around the year 2000. For amortizable facilities, they had a defined payback schedule that was tightly negotiated; for loans based on LIBOR or EURIBOR, they had a set margin; and for bonds, they had a fixed cash coupon. Loans had strict covenants, and an agreed-upon cushion known as headroom was set up beyond a coverage ratio to serve as an early warning system for covenant violations.
When a violation was anticipated, the borrower had a duty to alert the debt holders. After that, the terms were revised and subject to the lenders’ approval. Last but not least, loans were due in full upon expiration or in the event of a business event, which triggered a “change of control” provision.
Erosion of Duties Over Time
As is so often in the financial markets, things changed gradually until debt instruments underwent a complete transformation that was nearly unrecognizable.
The primary source of finance in recent decades has been credit. The frequency of reorganizations grew along with the level of financial risk. Even in the early 2000s boom years, there were many instances of struggling companies needing capital raisings or alter and extend (A&E) processes.
Future US president Donald Trump, for example, made the best of a bad situation in 2004 when he was attempting to save one of his resorts, stating, “We’re in the procedure of decreasing our debt by about $544 million… the interest rate from roughly 12 percent to 7.875 percent, and we’re extending the debt for a little over 10 years. It releases $110 million in cash flow annually. Around that time, debt contracts started to use looser procedures due to the booming economy. Remember NINJA loans? Even mortgages were provided without sufficient due investigation.
Contractual conditions that were more flexible favored corporate borrowers. Standstill agreements, which promise lenders won’t take legal action if a covenant is broken, became popular. Some trends favored high corporate debt users. Fellowship, or cov-lite, mortgages gained popularity in 2006 and 2007, giving borrowers greater freedom in conducting their businesses while restricting the choices available to creditors in the event of a default.
Taking Care of Cash Flow Shortfalls
The expansion of payment-in-kind (PIK) bonds was another craze that gained traction in private markets before 2008. These vehicles reduce immediate or short-term liquidity requirements by transforming bond dividend payments into non-cash things. As it becomes due, interest accrues and is paid at maturity with the principle. The credit boom of 2004–2007 made prudent liquidity management essential. Because coupon redemption was assured and timed, it made it challenging to distribute dividends.
PIK notes are very advantageous due to the influence that the value of time (TVM) has had on fund managers’ investment returns, freeing up funds to distribute dividends early in an investment’s life. Another element of loan packages that became increasingly prevalent was the elimination of any amortizable tranche. Historically, senior loan A, the tier of the debt structure that is the most secure, was part of leveraged deals. More leverage buyouts (LBOs) were funded without term loan A, resulting in non-amortizable “bullet” loans for all tranches, further decreasing the amount of capital needed.
“Equity remedies” were also common. These solutions solved the covenant breach issue by enabling private equity (PE) investors to contribute more equity to a struggling portfolio firm. When the economy deteriorated, the tendency turned out to be accurate. Relative to one-third a year prior and one-fifth in 2006, new equity injections were able to cure 46% of covenant violations in 2008. The public collapse of the EMI takeover demonstrated how adaptable these contracts had become. When the record publisher filed for bankruptcy in 2011, Terra Firma, the PE backer, had already spent several hundred million pounds fixing EMI’s net debt-to-EBITDA ratio violations. Terra Firma’s lender, Citi, had graciously given it “unlimited cure rights.” But it didn’t work out that way.
Avoiding and avoiding
A massive debt overhang plagued several zombie buyouts during the financial crisis. The stigma of repeated capital restructurings destroyed many. Financial backers took note of that experience. Since then, they have worked to remove all obstacles to the unrestricted practice of their craft. The last ten years demonstrate the strength of their negotiation position with lenders. Naturally, A&E became more mainstream, even if it was to get beyond the debt maturity hurdle. Some lenders grew more aggressive and attempted to seize ownership of failing assets, frequently through loan-to-own deals that were drastically reduced. Overall, though, PE owners were able to reschedule loans thanks to their long-standing, tight ties with their lenders.
Because of the TVM effect, loan renegotiations took longer and impacted returns. Buyout sponsors promptly made cov-lite loans available again. The Great Recession caused these structures to vanish. They made for more than half of the issuance of leveraged loans in 2013. By 2019, they made up over 80% of all originations worldwide. Much more significant post-GFC developments occurred.
Since 2014, PE firms have grown adept at manipulating the EBITDA, a non-audited operational cash flow proxy, using fictitious changes. However, pro facto or run-rate profits indicators have traditionally been used to convince partners to finance a company. Addbacks are used for one specific purpose: fixing possible covenant breaches without adding new equity, a costly procedure from the perspectives of both liquidity and rate of return.
Transferable Defining Portable
During the 2008–2010 credit crisis and its aftermath, these tools—A&E processes, loose restrictions, equity cures, bullets and PIK loans, add-backs, etc.—helped shift numerous debt-related costs and risks from the borrower to the lender. Yet, they fell short of totally removing the multiple dangers of long-term leverage. Giving debtors the option never to repay their loans or, at the absolute least, allowing debt redemption at their unilateral decision rather than at the whim of lenders would be the icing on the LBO cake.
This prospect has slowly materialized in recent years. Debt repayment is becoming increasingly optional: PIK toggles banknotes, also known as “pay if you wish,” loans in the banking industry. Debt portability, which makes maturity balloon payments voluntary, has also gained popularity. In such cases, a “change of control” provision is not triggered when a leveraged firm is transferred from one PE owner to the next. Given the popularity of secondary buyouts, this is essential.
Private capital firms have managed to impose mobility on dividend recap, even without any change in ownership taking place, because of their enhanced negotiating leverage, which is derived from a significant proportion of M&A transactions and their role as loan providers.
The Central Banker’s Put If lenders refuse to reduce financial risk by making the loans transferable, borrowers willing to limit the default risk should maintain hope. Another critical characteristic of a borrowing-centric economy is one they can rely on. While it was inconceivable for central bankers to spot an asset bubble and try to contain it, they could “mitigate the blowback when it takes place and, lets hope, ease the transition to the next expansion,” US Federal Reserve chair Alan Greenspan said in August 2002 as the dot-com bubble continued to deflate. Critics pointed out the flawed rationale underlying this claim. Why should Greenspan be more confident in his ability to predict the bottom of a cycle than the top?
In any case, Greenspan’s comments led to the inevitable conclusion that the Fed would step in during a crisis. This mindset, which reduces investors’ adverse risk, became known as the “Greenspan put.” The next problem materialized quickly, directly testing this “Fed-sponsored bailout” theory. Following the GFC, millions of US mortgage holders received assistance. The Federal Reserve bought mortgage-backed securities worth $1.3 trillion from Fannie Mae and Freddie Mac, the top two government-sponsored lenders in the US, from November 2008 and the beginning of 2010.
Central bankers have created a substantial system-wide moral hazard by promising that, if necessary, they will release debtors from the burden of debt commitments. Every individual and organization should take on debt in this “buy now, pay later” society if personal failure or bankruptcy is no longer an option. Since the start of the epidemic, Jerome Powell has joined his name to the series, making the Greenspan put into the Bernanke put. By setting a floor beneath asset values, central bankers are carrying out the will of their respective governments.
Unsustainable, hence eternal
Regarding the country’s balance of payments imbalance, Herbert Stein, the chairman of the Council of Economic Advisers during Presidents Richard Nixon and Gerald Ford, famously said: “If something cannot go on forever, it will cease.” But we have reached a point where there is no turning back regarding the federal debt. The entire unfunded government obligations in the United States, comprising pension entitlement, state welfare, and Medicare, already topped $200 trillion before the epidemic. Extreme leverage will always exist if a current Jubilee legislation is not passed through debt cancellation.
In the business sphere, there are already non-perishable loans with indefinite commitments. A creditor is always willing to modify a debt in exchange for payment. Perpetual in all but name is a non-covenanted, portable loan whose obligations are renewable indefinitely. Governments that want to have the perpetual right never to redeem their debt should take a page from the private sector’s playbook. If long-term obligations were transformed into perpetuities, 30-year Treasury bonds would become 100-year securities with low or zero yields. Of course, the word “bond” would be somewhat inappropriate, given the absence of a legally binding repayment obligation.
