Friday Letter: Doubling down

Buying up Citi’s loan portfolio is a bold move. The rewards are clear, but the risk is significant.  

The detail is all important on any deal but the fine print on Apollo Management, The Blackstone Group and TPG Capital’s offer to buy $12.5 billion of leveraged loans from Citi, the beleaguered US banking giant, should make for fascinating reading. Not least because early reports suggest they will be picking up at a discount of around 87 cents in the dollar some of the loans to their own portfolio companies.

Quite apart from the potential to give these companies a more sympathetic hearing, the sponsors, as owners of the debt, should also help to quell investor concerns at potential “zombies” in their funds.

“Zombies” are businesses with leverage on the balance sheet where the debt has become so badly impaired that they are worth less than what is owed to creditors, but generous covenants mean there is no way for the banks to force them to restructure.

This may not matter much to private equity firms who can to hold their investments until the value recovers. But it is fast becoming an issue for limited partners having to mark the investments they own to market. Thus the potential for a fierce debate between a GP loath to write down his equity and an LP under pressure from an auditor is clear.

What’s more, talking to the buyout owners of a couple of “zombies” this week made obvious that as far as they are concerned investor sentiment is more of an issue than actual business performance. Good credits are being tarnished along with the bad.

For private equity firms buying the debt in their own deals is a bold solution to this problem. It shows belief beyond the market’s ability to price debt in these turbulent days and it could give a floor to the distress from which the market can stage a recovery.

Investors, however, might also be concerned by the concentration risk the strategy presents. Following the Citi deal, Apollo, TPG and Blackstone will own equity and some of the debt in a number of highly geared investments. In other words, they are betting the ranch and they had better be right.