(BBG) Masayoshi Son and Elon Musk leveraged their dreams to the hilt. Patrick Drahi stockpiled debt to build a global cable empire. Michael Dell loaded his computer company with risky loans to buy out activists threatening his control. And a group of Chinese developers borrowed big to expand in the nation’s booming property market.
Call them the titans of junk.
They’re the headliners in a decade-long, $11 trillion corporate borrowing frenzy, fueled by central banks that flooded the global financial system with ultra-cheap money. Investors have been lending to virtually anyone willing to pay a decent yield. But now the easy money is coming to an end. Policy makers, after driving interest rates to unprecedented lows, are hiking those rates for the first time in 10 years. For many companies, it will bring new financial pressures. And for some of them, those pressures could trigger disaster.
Bloomberg News delved into corporate filings, debt offerings, M&A deal tables and bond indexes to find the biggest beneficiaries of this decade of loose lending. The search identified 69 companies spanning the globe that have boosted their debt levels by 50 percent or more in the past five years and now have at least $5 billion of debt. Together, they’re sitting on almost $1.2 trillion of bonds and loans, most of it rated junk and the majority due within the next seven years.
While many are household names like Dell Technologies Inc. and Tesla Inc., others are privately held entities that avoid the scrutiny of the S&P 500 crowd—companies such as specialty-chemicals maker Avantor Inc. and IT firm BMC Software Inc.
But chances are that anyone who socked away cash into a retirement account during the past five years has lent them money. Investors have parked trillions of dollars in mutual funds and exchange-traded funds that buy junk bonds. Pension funds in Canada have started leveraged-finance lending operations. Insurance companies have helped bankroll leveraged buyouts. And, in an echo of the subprime mortgage bubble a decade ago, investors from Sydney to Seattle snapped up hundreds of billions of dollars in AAA rated securities known as collateralized loan obligations that are actually backed by the debt of junk-rated companies.
The central banks that enabled the borrowing will now have to manage a precarious dance: weaning markets off their stimulus without triggering a stampede from one of the most crowded trades in a generation. That could culminate in a full-blown crisis.
“There can be a self-fulfilling prophecy here,” said Christian Stracke, global head of credit research at Pacific Investment Management Co. in Newport Beach, California. “These companies really do require confidence, and if you have a mix of market volatility with unexpected fundamental weakness, then that could create a much more difficult situation than investors are expecting.”
Until then, there are few signs that the borrowing is slowing down. But there are plenty of signals that its only getting riskier. In the past 18 months, institutional investors have snapped up $1.6 trillion of leveraged loans in the U.S. alone, data compiled by Bloomberg show. That’s more than the three previous years combined. What’s more is that private-equity funds, which typically use junk debt to fund the bulk of their buyouts, are sitting on record amounts of money earmarked for such deals. In other words, more junk-debt titans are likely to emerge before it’s over.
“Where this ends is so difficult to say precisely because of the amount of dry powder that’s been raised,” said Danielle DiMartino Booth, founder of Quill Intelligence and a former adviser to the Federal Reserve Bank of Dallas who also writes for Bloomberg Opinion. “You could have the inadvertent effect of prolonging a very dangerous credit cycle.”
For empire builders, the easy money has been the perfect source of cheap funding. Here’s how several companies are now trying to manage their debt burden:
SoftBank Group Corp.
Son, the big-dreaming billionaire founder of Japan’s SoftBank has gained attention the past few years for raising the world’s biggest tech startup fund, the Vision Fund that’s targeting $100 billion. But that number is dwarfed by the more than $149 billion of debt that the company has also amassed, an almost four-fold increase over the past five years. As Son wrote checks for billions of dollars to fund companies including office-sharing startup WeWork Cos. and ride-sharing company Uber Technologies Inc., SoftBank was also tapping debt markets for tens of billions to fund acquisitions including U.K. chipmaker ARM Holdings and U.S. asset manager Fortress Investment Group.
Even many of the startups that Son funded are now joining in the borrowing bonanza. WeWork, which lost $934 million last year amid a rapid global expansion, issued $702 million of junk bonds in April. Uber raised $1.5 billion from a leveraged loan in March, and demand was so high that it returned to the market two months later to shave half a percentage point off the interest payments off an existing loan.Son’s view is that SoftBank’s leverage should be seen as negligible because of big investment gains, mostly fueled by its 29 percent stake in Alibaba. When including cash and liquid assets and excluding debt for which the holding company isn’t responsible, SoftBank’s borrowings are just 29 percent of its total holdings, spokeswoman Hiroe Kotera said. “This is a safe enough level that even if the stock market crashes, we should be able to deal with it easily,” she said, adding that the company has enough liquidity to handle bond maturities for the next three years.
That’s not helping to ease the minds of creditors who are concerned that SoftBank’s ability to repay its debt has become tied too closely to the whims of the stock market.
“Tech companies’ stock prices can fall sharply at bad times,” said Takahiro Oashi, senior fund manager at Asahi Life Asset Management. “They are more vulnerable to a double whammy of economic downturn and interest rate increases than regular, conventional companies.”
Plenty of other companies have convinced debt investors to suspend what used to be standard demands, like a track record of generating cash flows. (Lenders stand to gain little of the upside but face a ton of downside if a borrower’s projections fail to materialize.)
Netflix , the video-streaming company that eclipsed Walt Disney Co. this year to become the most valuable media company, has tapped the junk-bond market for more than $6 billion over the past five-and-a-half years to help it keep churning out shows for its subscribers.Netflix, which didn’t respond to a request for comment, burned through more than $4 billion of cash the past four years as its debt load grew to more than seven times its Ebitda (earnings before interest, taxes, depreciation and amortization). And analysts expect more to come. Morgan Stanley is predicting that Netflix will return to the debt market this year.
Then there’s Musk’s Tesla . When the electric-car maker asked junk-bond investors to lend it $1.5 billion last August, it brought one of its long-awaited Model 3s to the courtyard of the New York Palace Hotel. The company was burning through the equivalent of $8,000 a minute to ramp up production of the car, intended to be Tesla’s first electric vehicle for the masses. But within a few hours, it had orders for $600 million of bonds. After a week, there was so much demand for the debt that Tesla raised an extra $300 million, pushing the company’s total debt load to more than $10 billion.
Tesla ended up paying 5.3 percent on the bonds. To put that into perspective: it’s about what bond investors were earning from 10-year Treasuries in mid-2007 before the Fed started trying to fight the financial crisis by slashing rates.Unfortunately for the buyers of the Tesla bonds, the losses came almost immediately as a series of setbacks fueled doubts that Tesla could meet its production goals. By April, the debt was trading at 87 cents on the dollar. Two months later, with the bonds still deeply discounted and doubts persisting over the company’s manufacturing capabilities, Musk announced the biggest job cuts in Tesla’s 15-year history as part of a broader effort to dial back the company’s frenzied spending. A spokesman for Tesla declined to comment.
He’s not the only junk-debt titan who’s had to check his ambitions.
After a torrent of deals that helped him amass cable assets from Israel to Portugal to the Dominican Republic, Drahi’s companies were left with a pile of almost $60 billion in junk-rated bonds and loans. The Moroccan-born billionaire has gloated that the wide-open debt markets have allowed him to grow Altice with little risk to himself. His borrowing binge included two of the biggest junk-bond offerings ever.
But Altice’s efforts to turn around one of its biggest acquisitions, French telecom company SFR, were stunted amid competition from cheaper mobile plans. A profit warning in 2017 spooked shareholders and at one point wiped out a third of its market value. As part of an effort to shore up its ailing European unit, Altice decided last year to spin off its U.S. business, splitting its massive debt load between two entities—Altice Europe and Altice USA.Drahi’s companies will need to keep pushing out debt maturities in the coming years to avoid getting into trouble, said Mark Chapman, a senior analyst at CreditSights Inc. in London. With $9 billion of Altice Europe’s debt maturing in 2022, the company will need to convince bondholders they can generate enough cash.
“The size of the structure is so big and the dynamics that are affecting it are quite complicated,” Chapman said. “Fundamentally the leverage structure doesn’t really work at too-high rates.”
Representatives for Altice Europe and Altice USA declined to comment.
For some companies, the strains are already materializing. In China, where the government has been seeking to curb real estate speculation and rein in unprecedented borrowing in its corporate sector, developers such as China Evergrande Group and Country Garden Holdings Co. have been battered in debt markets in recent weeks. And the U.S.-China trade war isn’t helping matters.
But many other companies say they’ve been aggressively seeking to pay down their debt. Dell, which boosted its debt load to about $49 billion after its 2013 buyout and 2016 takeover of EMC Corp., has since whittled that number to below $40 billion. The company, which is also planning to take itself public again, told investors this month that it’s committed to paying down enough debt to win back an investment-grade rating.
It’s not as if regulators didn’t attempt to keep the borrowing in check. The three primary entities that oversee the U.S. banking system—the Fed, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp.—began cracking the whip in 2013 on banks that underwrote debt that they considered too risky. One no-no: any loan deal that loaded a company with debt more than six times its Ebitda would get extra scrutiny, and barring any offsetting factors, those banks often were slapped with warnings.
But that barely made a dent. Even as the big banks turned away the riskiest borrowers, a host of firms that fell outside the purview of banking regulators—securities brokers, boutique investment banks and even pension funds—swooped in to underwrite those loans. Instead of capping leverage in the market, it continued to grow.
That’s particularly been the case in the leveraged loan market, which has overtaken junk bonds as the biggest source of risky corporate debt. A decade ago, there were only about 60 firms arranging leveraged loans, data compiled by Bloomberg show. By last year, that number had ballooned to 151 as smaller, less-regulated firms like Jefferies Group, Antares Capital and Australia’s Macquarie snapped up market share from top-tier lenders including Bank of America Corp. and JPMorgan Chase & Co. Even private-equity firms—whose buyout targets were often the ones borrowing to fund the deals—started underwriting shops to get in on the act.
With more underwriters falling outside regulatory oversight, leverage in M&A-related deals tracked by debt-research firm Covenant Review climbed from 6.4 times Ebitda in the first quarter of 2015 to more than 7.7 times during the first three months of 2018—well over the regulators’ old cap of six times.
And even those figures could prove to be larger than they seem, thanks to accounting adjustments that let companies ratchet up the earnings projections that are used to convince prospective lenders that their investments will be safe. Companies funding buyouts and takeovers are lowering their projected leverage ratios with cost savings or income that may or may not materialize. That practice, referred to as “add-backs” allows companies to pile on greater amounts of debt relative to earnings.
Consider Avantor Inc., a Pennsylvania-based company backed by private equity firm New Mountain Capital LLC that supplies materials to the biotech and healthcare industries. Avantor borrowed $7.5 billion last year to fund the purchase of VWR Corp., telling lenders that the combined companies would generate more than $1 billion a year in Ebitda.
But almost half of that number came from so-called add-backs that allowed the company to include expected cost savings or increased sales. One example: the company included sales it expected to reap by convincing VWR customers to buy Avantor’s products instead of competitors’. The boosted earnings projections allowed the company to market the deal with a leverage ratio of seven times Ebitda. Moody’s Investors Service, which gave the loan a rating six levels below investment-grade, said the company was unlikely to meet those earnings projections, and it estimated the debt at nine times Ebitda.
Such lofty projections are becoming increasingly common in the fine print of loan documents. Covenant Review, which scrutinizes the risks in loan terms for its investor clients, says that about 30 percent of the Ebitda figures used to calculate leverage in loan deals this year was made up of add-backs. That’s up from just 10 percent in the first quarter of 2015.
All of this means that when markets do turn, investors may be in for a rude awakening.
The bonds they own may end up being worth less than they expect. Companies may find that the lines of investors clamoring for their debt may not be there the next time around. And if panic ensues, regulators who have been laser-focused on preventing another meltdown in the banking sector will suddenly have a new group of shadow lenders to worry about.
Moody’s has already started to warn that investors could end up recovering substantially less in bankruptcies than they have historically. One of the reasons leveraged loans have attracted so many buyers is that they have always been viewed as the safest type of debt you can buy because they are the first in line to be repaid when a company goes bust. Problem is, as companies increasingly tap that market for their borrowings, those lenders are finding that there’s no one left behind them to cushion the blow.
“The effect of that when it happens will be larger than people expect because it’s like a coiled spring,” said Dan Zwirn, chief executive officer at Arena Investors, which manages about $1 billion in investments including loans to small-to-mid-sized companies. When yield-chasing investors “finally feel that shock, whatever that shock is, they’ll be surprised about the actual underlying credit quality of what they own—and then realize that what they thought was liquid actually has no bid. Then we’ll see fire and brimstone.”