Tuesday, March 15, 2011

Risky Business in Asset(less) Lending

Retail investors have been on a hunt for debt based yield ever since Bernanke announced QE 2.0 last year. However, most bargains had already been snapped up earlier in 2009 by savvy fund managers. Most of the best issues have already been priced out of the market as reflected in lower interest rates. This was a win win situation for both debtors and lenders as the former were able to refinance at a critical time while the latter was able to achieve impressive gains.

But as the year progressed, less financially sound companies began to seek similar sources of funding among investors. Those who missed the initial rally in high yield issues have piled onto riskier and riskier issues. The principal cases in point are the recent surge in covenant line loans, pik toggles (payment in kind), and other mezzanine based debt structurings.

These types of deals were blamed by some critics for being a harbinger of the financial crisis in 2006-2008. The higher returns being offered to investors are a reflection of the greater risk involved to junior creditors. The most worrying parts are loan provisions that allow a borrower company to default in the event of deteriorating finances or even natural disasters such as acts of god. Unlike senior note holders, junior creditors are usually left holding the proverbial bag in case of a default. They are usually unsecured, or lack collateral, in their underlying loans.

So, what are some warning signs of a potential default? Here is a short list - large borrowings to pay special dividends, large bonuses paid to management, poor cash flow, goodwill comprising an unexpectedly large part of the balance sheet, and potential legal suits.

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