Monday, September 30, 2013

Blackstone Sees Epic Credit Bubble?

Lawrence Delevingne of CNBC reports, Blackstone: We're in an 'epic credit bubble':
One of the world's largest investment firms believes the financial system is overly leveraged.

"We are in the middle of an epic credit bubble, in my opinion, the likes of which I haven't seen in my career in private equity," Joseph Baratta, The Blackstone Group's global head of private equity, said Thursday night at the Dow Jones Private Equity Analyst Conference in New York City. "The cost of a high yield bond on an absolute coupon basis is as low as it's ever been."

Baratta said Blackstone is "bullish" on the U.S. economy, but the "valuations we have to pay relative to the growth prospects are out of whack right now."

Baratta said the U.S. still has "clear headwinds" and is "range bound" between 1 percent and 3 percent economic growth.

Blackstone, which manages $53 billion in private equity assets and $230 billion overall, is pursuing select investment opportunities in energy, transportation infrastructure, consumer finance, housing and construction, according to Baratta.

"We're not just levering up U.S. GDP into multiples today," Baratta said. "I do expect mean reversion to happen at some point on interest rates, on credit spreads, on the cost of some investment grade corporate credit."

The high valuation of many companies today makes it harder for them to grow. "The biggest risk to returns of this vintage is that exit multiples are depressed," Baratta said.
Baratta's comments serve as a warning to institutional investors piling into private equity. As I've previously discussed, the pressure is on private equity funds to find attractive deals in this environment and while investors are maintaining their allocations, they are turning lukewarm on the asset class and see lower returns ahead. Moreover, the move toward Asia hasn't delivered the returns PE funds are accustomed to and big investors are sounding caution in that region.

In terms of credit markets, Cullen Roche of Pragmatic Capitalist sees the logic in Baratta's bubble theory:
Yes, while everyone focuses on the stock market, the real disequilibrium that has been potentially built up over the years has been in credit markets where the portfolio rebalancing effect has forced investors out of risk free US government bonds and into assets that serve a similar purpose in a much riskier credit structure. We’ve taken another safe asset class and forced this massive rebalancing of portfolios that has resulted in investors chasing yield to the point of actually making the market potentially more unstable than it otherwise would be.

Of course, this all works fine so long as the income is there to support the credit structure. But the big risk is a recession or a big profit recession where companies are no longer seeing the cash flows. That’s when the big risks present themselves. And if that were to occur we’d see a mass exodus out of many of these private credit markets in search of the true safe assets – US government debt. And if the Fed is still siphoning the risk free asset out of the private sector when investors most want it this could actually exacerbate the problems in other markets as the exodus into cash and cash like instruments ensues. Think 2008 style US T-bond rally all over again.
But not everyone buys the bubble theory in credit markets. Ben Eisen of MarketWatch reports on how the junk bond credit clock is moving slower this time around:
Cries of a credit bubble appear to be coming back into vogue.

Take, for instance, Joseph Baratta, The Blackstone Group‘s global head of private equity, who reportedly said at a conference on Thursday: “We are in the middle of an epic credit bubble, in my opinion, the likes of which I haven’t seen in my career in private equity.”

But in the high yield bond market at least, if there is a bubble, the chug toward any sort of pop appears to have been slowed down by a lethargic economy and a responsive Federal Reserve.

High yield, or junk, bonds tend to move in a cycle characterized by fits and starts, as the balance sheets of these lowest-rated companies strengthen and weaken. While the means of labeling it vary, Wesley Sparks, head of taxable fixed income at Schroders, categorizes the so-called “clock” of high yield credit quality into four categories.

It starts with “repair” in which balance sheets improve and cash generation efforts increase; then comes “recovery “efforts to boost cash flow and expand margins; “expansion” follows, defined by falling margins and rising leverage; “downturn” comes after that, as the economy slows down and defaults rise, prompting companies to begin the “repair” phase all over again.

The repair-to-downturn cycle went all the way through between 2002 and the beginning of 2009. This time around, Sparks pegs the junk bond market in the middle of the “expansion” phase (right around 7 o’clock), nearly five years after the cycle ended (click on chart below).

The slower pace comes from the sluggishness of the economic recovery, he says. Companies tend to increase their leverage as the economy picks up steam, while credit standards tend to drop. To slow down the time before defaults inevitably rise is a good thing for the junk bond markets.

“This credit cycle has been slowed down because of the slow-growth environment, but it’s been stabilized by an accommodative Fed,” Sparks said in an interview Tuesday. “In the current environment, credit is quite constructive.”

But not all high-yield sectors move around the clock at the same speed. The slow pace creates some differentiation. For example, in the expansion phase we are currently in, cyclicals like consumer and chemical companies are tending to do well, he said. Once the downtrend hits and defaults rise, other sectors like food and beverage and healthcare may become more attractive.
Finally, it's worth noting that Baratta's comments stand in contrast to the bullish tone of Blackstone President Tony James who told Bloomberg last week the good times in the buyout market are just starting:
Blackstone Group LP President Tony James said the “good times” are just starting for private-equity firms because the U.S. economic recovery is still in its early stages, Europe has stabilized and China is rebounding.

“I don’t see the good times coming to an end for quite a while, absent some global shock,” James said in an interview airing today with Bloomberg Television’s Erik Schatzker at the Clinton Global Initiative in New York. “I’m not sure the stock market doesn’t have a long way to run still, and the economy certainly still has a long way to run.”

Profit at New York-based Blackstone more than tripled in the second quarter from a year earlier as the firm, led by James and Chief Executive Officer Stephen Schwarzman, took advantage of rising stock markets to sell holdings and take portfolio companies public. Now is a better time to sell than to buy as interest rates kept low by the U.S. Federal Reserve allow buyers to finance acquisitions at high prices, Schwarzman said at the Sept. 24 Bloomberg Markets 50 Summit in New York.

‘Recovery Thesis’

Private-equity firms depend on both selling and buying companies to make money for investors, who expect to earn their money back with a return five to six years after it’s put into a deal. Bill Conway, Carlyle Group LP’s co-chief executive officer, said on Aug. 7 that the investment environment has grown more challenging, sending shares of Washington-based Carlyle down 1.2 percent.

Even in a competitive climate, Carlyle has raised more than $10 billion for its newest buyout fund, Carlyle Partners VI, exceeding its target.

James’s comments were echoed today by Alex Navab, co-head of private equity for the Americas at KKR & Co. (KKR), who said the U.S. economy will continue to grow over the next three to four years. The U.S. private sector is growing at a healthy pace despite obstacles such as the federal debt and lack of action in Congress.

“Our view is that the private sector has grown three-plus percent and what’s really been a drag to GDP has been the government issues,” Navab said at the Dow Jones Private Equity Analyst Conference in New York. “We think the economy has further to go, through 2016 or 2017. Today is actually a good time to be investing, particularly in a recovery thesis in the U.S.”

European Deals

Higher interest rates would create “turmoil,” giving Blackstone (BX) and its private-equity peers opportunities to buy assets at low prices, James said in the interview at the Clinton Global Initiative. The benchmark 10-year U.S. Treasury yield rose to 2.64 percent as of yesterday from as low as 1.63 percent in early May, before the Fed began stoking speculation that its asset purchases may be nearing an end.

Blackstone has shifted its focus for new deals to Europe and Asia from the U.S., said James, as Europe stabilizes and China finds its economic footing.

Deal making in the U.S. has slowed. The number of private-equity transactions announced this year through yesterday dropped 16 percent compared to the same period last year, according to data compiled by Bloomberg.

“There’s just not much out there to buy,” James said. “There aren’t many corporate sellers -- why that is, we can speculate -- but there just aren’t.”

James said he’s disturbed that markets haven’t reacted more negatively to the impending breach of the U.S. debt ceiling. Investor “complacency” allows Congress and President Barack Obama to delay deciding whether to raise the ceiling until the last minute, he said.

“That’s one of the most dangerous things about this cycle,” James said. “If you can push it to the limit, there’s a high possibility of miscalculation.”
We shall see what surprises Washington has in store for us. I've already warned my readers of nasty surprises that lurk ahead and think that investors are starting to fear the worst, and rightfully so.

Below, Blackstone Group LP President Tony James talks about the outlook for the company, financial markets and the private equity industry. He spoke with Bloomberg Television's "Market Makers" host Erik Schatzker at the Clinton Global Initiative in New York.