Realogy, Apollo and Equity Cures
With the federal funds rate crossing 5.25% and reaching a 20+ year record high, many analysts expect rates to peak relatively soon. Although many debate about whether predicting the direction and timing of short-term rate movements is a fruitless endeavor, the impact of these recent rate hikes on buyout activity and specifically leveraged loan issuances is not debatable.
While US leveraged loan issuances reached nearly $48bn last quarter–which beats the ~$40bn of issuances each quarter since mid-2022–the vast majority of this, over 60%, was due to refinancing activity. Yields on these new issuances have crossed 10% for new B/B+ borrowers, up from 7.5% just a year ago. This is largely due to rate hikes, as spreads have not widened much, staying around 400bps since mid 2021.
But this is common knowledge. Financing has become increasingly expensive over the last two years, which has led to muted M&A activity, and affected LBOs as well. However, this post will focus on the tightening of lending standards for LBO debt, resulting from the lower investor demand for leveraged loans, as well as its impact on sponsor activity.
We’re already noticing the impact of this on sponsor-backed companies during recent liability management transactions intended to raise new financing, often at the detriment of existing lenders. Looser restrictions and credit agreements have allowed for a more flexible interpretation of the debt documents. The recent At Home “double dip financing” transaction seems to the best proof of this, along with numerous non-pro rata uptiers and dropdowns in recent years. As documents tighten and these loopholes are addressed by lenders during new issuances, it can be expected that this crack down will place greater pressure on sponsors loooking to raise new money for portfolio companies.
One area that will likely be restricted further given these new lending standards is the equity cure, a provision allowing sponsors to inject equity into the company, typically in order to avoid a covenant breach. While at first this seems like an easy way to stave off technical default, I was interested to learn that lenders are often incentivized to limit equity cures within credit agreements. These limitations may come in the form of restrictions around the source of the equity capital, timing of payment, use of any proceeds and interestingly, limits on the dollar value of the equity cure (often calculated as an EBITDA multiple).
It may seem counterintuitive for senior lenders to limit the amount of additional capital that a junior stakeholder, often the existing sponsor, can provide. For distressed companies, an equity cure is simply a method for the sponsor to write a check to lenders as the capital injected would likely need to be used to repay senior lenders in full anyway. So why would lenders impose a cap on this? Well, by repeatedly avoiding technical default through cures, a sponsor would be able to prop up an underperforming business for an extended period of time, leaving lenders to deal with the headache and uncertainty of unpredictable future cash flows. Additionally, by forcing default, lenders can accelerate payment or use it as a means for extracting beneficial terms through a covenant waiver.
While lenders are perhaps more likely to impose a stricter hard cap on the number of equity cures available to sponsors moving forward, the ability to use the equity cure in order to achieve compliance with covenants may face greater scrutiny as well.
Realogy
An interesting example of the equity cure can be seen in the case of Realogy, an Apollo-backed company. Realogy provided residential real estate and relocation services to customers around the world. Their core business was concentrated in real estate franchise services, where brokers working under a franchise model who represented buyers / sellers in residential real estate transactions would earn a commission on closed deals. Realogy would then earn a fee as a percentage of the franchise’s commission. This was their largest business by far, and the company claimed to be involved in 1 out of every 4 single family home transactions in the mid-2000s. Other smaller businesses included relocation services that they offered employees as well as a title insurance business.
The company was acquired by Apollo for nearly $7bn in 2007 at an 18% premium, representing a 12x multiple. Given that competitor Countrywide was acquired at a 9x multiple 6 months prior to Realogy’s acquisition, I believe that the premium may have been slightly high but not unreasonable. The deal was highly leveraged with over $6bn of debt, but supported by an investment thesis claiming that the geographic diversity of Realogy’s franchise model avoided local / regional real estate market exposure and therefore mitigated any downside risk. Liquid financing markets were able to support the LBO as well, despite home price growth slowing by 2006.
The investment thesis was tested a few years later. The entire US housing market crashed, so limiting regional exposure through Realogy’s franchise model was not enough to save its top line. Revenue fell from nearly $7bn in 2006 to $4bn by 2010 as new home sales cratered and home prices fell. At the same time, the company’s interest expense ballooned and with significant negative free cash flow, the company’s unsecured debt was trading at around 10 cents on the dollar by 2010.
Realogy’s equity cure provision in its credit agreement for its senior secured debt gave the sponsor significant flexibility to avoid tripping its covenants. In its credit agreement, the company’s total senior secured debt covenant required a leverage ratio no greater than 4.75x. However, with Adjusted EBITDA falling from nearly $1.2bn to $400mm in the span of three years by 2008, the ability to remain compliant with the covenant was put into question. An event of default of the ratio could be avoided through an equity cure by Apollo. An equity cure was included in the definition of covenant Adj. EBITDA for the company, and so Apollo could have injected new equity into the business to increase covenant Adj. EBITDA.
Now Apollo did not end up relying on this provision to save Realogy. As mentioned before, the company was deeply distressed with junior debt trading practically close to 0. In such situations, the sponsor may see more value in buying the debt at a steeper discount instead of injecting equity, although this does require that a large-enough group of debtholders are willing to sell their debt at a discount. By buying the debt back at a discount, Apollo was able to better align the debtholders’ incentives with those of the sponsor (Apollo in this case) through what some now view was a form of modified strip financing. The transaction also reflected the sponsor’s confidence in the company as it showed the market that the debt was not undervalued, at least according to Apollo. This was essential for Realogy given that numerous activists including Carl Icahn had purchased a large volume of unsecured bonds and were subsequently blocking initial restructuring plans put forth by Apollo.
However, this transaction does show how the relaxation of lending standards had allowed for the equity cure provision to avoid default, albeit for a relatively short period of time. The company did end up needing to renegotiate covenants with lenders but did not have to resort to that until late 2010, during which they also executed an exchange offer to allow for significant deleveraging.
Given that most sponsors will want to navigate distress outside of a Chapter 11 context, this will continue to be an interesting trend in the near future. In the case of Realogy, Apollo was able to avoid Chapter 11. Many predict that Apollo was looking to avoid bankruptcy as existing franchises were worried that their franchise agreements would be treated as executory contracts by the court and therefore rejected. Filing for chapter 11 would have fractured the relationship between franchises and Realogy / Apollo as a result. Additionally, given the large equity check (>$1bn), abandoning the investment would have reflected poorly on the company when turning to LPs for fundraising.
As lending standards continue to tighten in the future, the cap on equity cures will be especially interesting when looking at the credit agreements for sponsor-backed companies and sponsors may need to resort to other solutions such as Apollo’s modified strip financing strategy when considering alternatives to avoid default.
