sport football: Businesses in Structural Decline

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Welcome back!

I spent a lot of this piece thinking about frameworks for leveraged lending. When your upside is par, and when only a few bad deals can ruin a fund or CLO, you really need to make sure your impairments are negligible.

But let's be real - lending is a very competitive industry and efficient processes have a privatized version of "efficient market hypothesis" so you're ultimately going to have part of your portfolio comprise of companies you're a little less comfortable with, but have to play. Companies with 10% (or lower) exposure but 90% of the headaches.

Let's talk about how to manage these types of deals - but I also want to talk about managing an exit out of situations where you're bearish on where the Company is heading. In this section and the next sections, I'm going to talk about how you know whether its time to exit the ride.

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Dividend Recaps: A Window to exit

Dividend Recaps are a prime time when you can think about whether to exit the ride. You've had a good run lending to a certain company, but now the leverage profile is going higher - is it time to jump off?

An occasional critique I get in this newsletter is I don't really cover the 101 stuff and just get right into talking about credit. So as a quick refresher, a "dividend recap" is a "dividend recapitalization" - where a Borrower takes on incremental debt to pay a dividend to its Sponsor group. This typically happens mid-way through a Private Equity firm's journey with a Company - the initial LBO may have been at 7x leverage, the business delevers to 5x through growth and incremental debt paydown, so the Company decides to take some equity out of the business and relever back to 7x (a higher rate, but a level they were historically comfortable with).

There was a 2025 study, "Capital Structure & Firm Outcomes: Evidence from Dividend Recapitalizations in Private Equity" that checks out - the researchers found through looking at 1,572 dividend recaps that 10 years following the recap there was a 9.2% chance of distress, vs. 3.4% without the recap. And this makes sense, right - your debt load and interest payments are shooting higher. You can access the study here.

Incentives are important. Sponsors taking out a big chunk of equity, all of their equity, or all of their equity and some, can change their incentives very quickly. If the Sponsor loses incentive to support the business and preserve equity value, then this can be detrimental.

"How much equity does the Sponsor have in the business" is one of the more important questions you'll get in your investment committee.

However, as of late - the rise of liability management exercises (LMEs) has protected sponsor equity and pitted lenders against each other.

LME dynamics protect equity at the expense of creditors:

Sponsors would much rather have lenders take a haircut or be pitted at each other throats than take a haircut themselves. A lot of lenders will "happily" do so. And Sponsors will laugh about the discount to par that they've taken, as well as the extension they've received. Sure, credit docs are tighter post an LME, but the fact that they were loose to begin with was just a nice perk and weapon in the arsenal for the Sponsor.

Covenants are across the industry are weak, assets can get moved around in unrestricted subsidiaries, and "carrot and stick" and "deal away" dynamics are ever present.

In a well managed situation by the Sponsor, where a future refinancing and light at the end of the tunnel still looks feasible, the Sponsor can easily hire K&E and Moelis and coerce lenders into extending the runway and reducing the debt load.

But some Sponsors will happily make an equity injection, or an incremental debt injection, if they need to.

If you think an LMEs are mostly "costly failures" like HPS does, then you'll want to try to map out what an exchange looks like, and evaluate whether today's price is better than a post-LME price.

Repricings:

You might need to tell the broadly syndicated loan market that they don't have to cave to every borrower demand.

If you don't like the risk/reward setup, you can take the payout and move on to the next name.

Unfortunately, repricings generally happen with a Company that deserves a lower cost of capital (so these might be stronger companies that you're letting go of).

What worries me is seeing some large private credit deals with a low 4-handle - aka S+425-450 pricing - that's so tight in almost any environment and a reflection of how larger UMM deals are hyper competitive. This really gets back to my point on efficient-markets-hypothesis existing in the private markets - a Sponsor who knows how to run an organized financing process is going to maximize getting the most they can out of their credit agreements and terms. Even worse, efficient processes can happen at the LMM level too. Giving <11% rates (based on where SOFR is today) to companies skating by with very small amounts of EBITDA (and barely any FCF) is a recipe for disaster.

But I think my next point in this newsletter is the most important one - that a lot of the issuers in the leveraged lending market have no role in the world 10, 20 years from now - or will have very diminished roles, to say the least.

Overall, High Yield is Old Economy

The High Yield bond market's mix of companies that are "old-economy" is a risk for the asset class. Having unsecured positions in companies that don't have staying power and are getting disrupted everyday feels really unappealing. And it's not necessarily appealing from a career longevity standpoint as well.

A lot of why I spend so much free time learning about digital media and technology is because a lot of older media companies have been left in the dust. Radio isn't coming back, Broadcasting is a slow bleed, and Satellites have been destroyed by the rapid growth of Starlink. I've been spending a lot of time lately studying GEO - if you ask a high yield investor what GEO is, they'll say it means you're talking about geostationary satellites. Geostationary satellites have been completely disrupted by operators like Starlink shooting up a massive amount of lower-orbit satellites into space. But that's not the answer to my question. GEO = Generative Engine Optimization, a strategy to have AI-powered searches drive users towards your business or content. The way we search is getting flipped on its head, and GEO is going to eat up SEO as search share shifts to OpenAI, Gemini, and other AI models. Isn't that type of GEO so much more interesting than what the head-in-the-sand crowd thinks GEO means?

In a way, the High Yield industry is about guessing which companies, who will probably not exist in 10-20 years, are going to live just a little bit longer than consensus.

The typical High Yield investor is going to make a lot of money by correctly guessing "Hey I think this business dies in 10 years, not in 5 years" but I genuinely think there's a case where you can say "this isn't worth the brain damage. I know this company is toast within the next 10 years, why even bother going on a rocky ride and risk being wrong by a margin of error". Still, if you want a career in this industry, you're going to have to hold your nose, recognize the hair, and figure out what you can get comfortable with.

There's still a large cohort of High Yield and Loan indices that are staple, everyday businesses (Healthcare, certain building material and materials providers, essential services, etc.), but I'd argue a large swath of the high-yield and leveraged loan market is uninvestable on a 10-year time horizon.

Melting Ice Cubes:

If you're correct about the melting ice cube, but wrong about the timeline, then you were just, flat-out wrong. One of the businesses that has steadily hung around longer than most credit investors thought was DirecTV.

Let's look at Satellite TV - that's a business that has been dying for some time. The glory days ended a while ago. That business is in rapid decline. Still, you got paid handsomely if you hung around in DirecTV paper over the past several years.

So when do you hop off the ride? That's the toughest question. If you didn't hop on the ride to begin with, then you missed out on a high spread, higher-rated name that would've really helped with performance.

But how much longer should you stick around in the business? It's a really hard question to answer and maybe you need to plug your nose for some spread. But you should only plug your nose in situations where there is trading liquidity. If you're plugging your nose in private credit, which is highly illiquid, then there's a problem. Regular way private credit isn't a viable solution for businesses in structural decline - a lot more kickers (higher spread, additional PIK, Prefs, liquidation preference, warrants) are needed to make those deals worthwhile.

Just put the fries in the bag bro (Just sell the business):

Part of the art of being an executive is knowing when it's time to sell the business. Generally this is best done when times are good and there's still an expectation of steady growth in outer years but a reasonable downside case of things starting to fall apart during that period.

If you were coming off of some years of mid single digit growth, with expectation of 2% growth over the next few years, but a very likely situation where revenue actually declines by mid single digits for a few years, with today being your "peak" revenue and EBITDA number - you should probably sell the business. You'd be a lot worse off trying to sell when EBITDA is down mid-teens from where you were 2 years ago.

I always go back to Newsletter businesses as examples, but it was revealed that The Hustle and Morning Brew nailed the timing of when to sell. They didn't seem to have a massive buyer pool, and sold prior to a period where it became it a lot easier to make newsletters.

The simplistic economic reasoning of knowing when to consolidate is when you see a competitive environment that is acting irrationally in an unsustainable way. That without consolidation, five players are just going to beat up on each other in a way where no one really generates enough sustainable cash flow. The way streaming service platforms were behaving was irrational, and now it's clear there's going to be some sort of consolidation between Warner Bros. Discovery, Peacock, and Paramount Plus in order to create a more rational, scaled player.

A Known Seller is a Poor Seller: It's harder to think of a worse scenario than being a forced seller due to pressure to reduce leverage. The fact that you have a poor capital structure means the overall business is not attractive to begin with - and now you basically need to sell something or you'll restructure? Look at Byron Allen, for example, putting 28 broadcast TV stations up for sale. 1) Not sure who wants to even buy this and 2) These multiples will probably be pretty ugly. It's not like there's a strong, urgent desire to go out and buy a bunch of smaller-market broadcast TV stations.

Welcoming High Growth Companies to the High Yield Market:

Still, there are several fast-growth companies leveraging the high yield debt markets, or credit markets.

Databricks received $5.25B in private credit financing, with JPM serving as lead left, and financing from lenders led by Blackstone, Apollo, and Blue Owl. The financing comprised of a $2.25B recurring revenue TL, a $500mm DD-TL, (both are priced at S+450), and a $2.5B RCF.

Coreweave raised $2B in a HY bond offering that was upsized by $500mm, pricing at 9.25% for Sr. Uns.

Uber and Netflix were "Junk Bond" darlings, with Netflix having the moniker "Debtflix" which ultimately ended up being laughably wrong as Netflix wiped the floor with sub-scale players over the past few years.

Generally, Private Credit gets to see some faster growing companies with more exciting growth prospects, while the Broadly Syndicated Loan Market and High Yield Market receives more mature borrowers. That type of "dying company" mix in the index is a big problem for the asset class IMO.

You're Underwriting for the Next Deal

One PM I've worked for seems to have the philosophy of "thinking a deal ahead of the current deal" - aka if this next refinancing or exchange is going to be the Company's "last" then maybe you shouldn't even get involved with it. This isn't the case of "the business is too levered, but it's a viable business that needs to exist" - it's more of a case that the core fundamentals of the business are deteriorating. Underwriting on a 10-year timeline (one deal ahead) may be valuable than underwriting a 5-year timeline.

Conclusion: Look - a lot of the High Yield Bond market is old economy - if you're in your 20s or 30s right now, you need to think long and hard about what your borrowers and industry is going to look like in your 40s. A lot of the Companies you invest in are not going to make it 15-25 years - it is your job to imagine what the world looks like on a 3, 5, 7, 12, 20-year timeline and how your investment is impacted. If you're investing in a dying company where you're uncertain how it looks in 1 year, you should probably exit. You also need to tie this to your career - are you tied to investing in things that are growing or things that won't exist in its current form for much longer?

There are only so many opportunities in life to take the optimal exit ramp - so don't squander the opportunity to say goodbye to companies that fit any of the 1) old economy 2) melting ice cube and 3) unsustainably overlevered buckets.

Until next time,

Harry.

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