Actionable Ideas: Discount Exchanges as a Deleveraging Strategy

Actionable Ideas for Companies and Sponsors

Companies with multiple tiers of debt trading at a discount to par often examine ways to repurchase the debt to capture a discount; thereby deleveraging their balance sheet.

Typically, however, these companies lack ready access to capital to fund debt buybacks. In these situations, there may be an opportunity for long-dated maturity or unsecured bondholders to exchange their debt into instruments with collateral, guarantees, shorter maturities or other enhancements to induce holders to participate in the exchange.

A contemplated discount exchange is often most effective when the issuer faces future uncertainty as to its ability to repay longer dated debt or the capital structure implies significant downside for junior or unsecured creditors in the event of a bankruptcy. In these circumstances, bondholders typically value their existing debt on a yield to workout basis; more specifically, investors estimate a future reorg value, applying the cap structure in order of payment priority and then estimating the recovery to their class. To the extent there is further downside, bondholders may act defensively, allowing issuers to exchange bonds, at a discount, with features (i.e., collateral) that provide downside protection in a reorganization in exchange for existing debt and, in doing so, incrementally reduce debt with little or no upfront cash.

Hedge Funds Continue Resilience through Market Turbulence

Shannon Murphy, Managing Director and Head of Strategic Content at Jefferies, delves into the evolving market landscape for American hedge funds. With funds overseeing a record number of assets and market-wide volatility on the rise, fund managers are confronted with an array of new challenges and opportunities. Murphy examines the industry’s potential for continued growth, emphasizing the importance of agility and adaptability amid turbulent conditions.

2023 marks a fascinating inflection point for the hedge fund industry. There are approximately 8000 hedge funds today, which is essentially the same number we had a decade ago, but they are managing nearly double the assets. This makes for a pretty competitive landscape as firms vie for that incremental dollar.

This competitive environment emerges just as our investing landscape undergoes a period of transition. Allocators are revisiting their portfolios, deciding how to position themselves for the next five to ten years. It’s a very exciting time for funds who can manage volatility across cycles. A lot of these partnerships are being renewed, refreshed, and rebuilt for the next decade.

As allocators revisit their portfolios, the industry now has a four-year track record of solid performance, outperformance, and capital protection. First, we saw three years of double digit performance, the first time that that’s happened since the late nineties. Then, last year, hedge funds protected for the best time in 15 years, all during a period when the VIX traded above its historic average 95% of trading days. These are the sort of numbers that make me really excited about new leaders on both sides of the aisle: new managers and new allocators.

As managers go back to the basics, this environment almost becomes  ‘P&L 101’. How does what you’re bringing in match what you need – not just this year, but in 2024 and 2025, too? Hedge funds can massively outperform the indices (as we saw last year), but maintaining a stable and agile business requires one to strike an appropriate balance with incentive and management fees.

Periods of transition herald a lot of opportunity. If you’re a manager that is willing to revisit your assumptions, you can create new muscle memory by adapting to a new investing regime. Every generation goes through this, and there’s a dichotomy between those who have lived through an economic transition and those for whom this is a first. It’s critical to build a strong foundation, but also build agility into your organization, your investment process, and your risk management process.

Today’s market can be summarized with one word: rates. The industry needs to remember the implications of a rising rate environment for their businesses, their portfolio companies, and counterparties. Managers must assess their competitive position and ability to invest in talent, capitalize on dislocations and opportunities, and utilize new assets, investing processes, risk management frameworks, and data sets.

We’re operating in a period of new market circumstances and strange contradictions. In just the first 100 days of the year, we have had the biggest and fastest bank runs of all time. We’ve had historic intraday volatility, and yet, certain indices like the Nasdaq are having a very strong run. Amid these conditions, it’s critical to treat your partners as a sounding board.

The hedge fund industry experienced slow growth over the past decade. In some cases, organic performance was muted, but in other instances, firms showcased how they built the dominant $4 trillion industry we see today. Last year, we saw $55 billion in outflows, but those redemptions slowed in the fourth quarter and that’s typically when they accelerate the most. As we look forward, I feel optimistic that this could be the decade when hedge funds truly shine.

Survivors of the last decade are poised to take calculated risks and adeptly navigate volatility that challenges other asset classes. As transitions inherently create winners and losers, this decade will forge new household names. As we look to what comes next, two qualities will be critically important: imagination and efficiency. Funds must embrace both if they hope to successfully maneuver this new environment while capitalizing on fresh opportunities and forming new alliances along the way.

Predictions for the Private Internet Market

Ahead of Jefferies’ Private Internet Conference, we had the opportunity to speak with Gaurav Kittur, Global Co-Head of Internet Investment Banking, and Cameron Lester, Global Co-Head of Technology, Media, and Telecom Investment Banking. They offer insight into the challenging investment landscape of 2022 and expressed optimism for a brighter 2023.

Many internet companies are better positioned today to navigate a still challenging macro environment after spending the last year focused on cost discipline and streamlining operations. However, they face financing terms that have shifted to favor investors, a sharp contrast to what we saw in 2020 and 2021. In 2023, new investments will continue, with investors likely favoring companies that balance top-line growth with profitability. Here are a few other developments Kittur and Lester think investors and companies can expect as they navigate the new normal.

Q: As we approach the halfway point of 2023, how do you view the current market landscape for private tech and internet companies? Is there reason for optimism?

GK: Since mid-2021, we’ve faced an incredibly tough environment, particularly for consumer-focused internet and technology companies. In general, public companies in this sector have traded well below issue price, and VC and growth investing has significantly slowed in the private markets.
Consumer internet companies have seen customer acquisition costs skyrocket. Changes in privacy rules have made it more difficult and expensive to target new groups of consumers, and businesses have also had to reduce their marketing budgets, causing growth to decelerate. The silver lining is that amid a changing macro environment and tighter funding, CEOs are implementing greater discipline into their businesses. Companies have completed RIFs [reductions in force] and are more focused on targeting high-value, profitable customers. Companies demonstrating cost discipline and profitability will have better access to capital. On the investor side, many funds have raised significant amounts of capital but have yet to deploy it. They are ultimately paid to deploy capital, so there is considerable pent-up investor demand to support companies positioned to emerge stronger from the current environment.

Q: Are investors now more willing to sacrifice growth for profitability?

CL: Internet investors will always be drawn to growth. They look for large, rapidly expanding markets experiencing digital disruption, where technology is augmenting or replacing the status quo. Growth is the most dominant element that can drive alpha. With today’s capital scarcity, growth paired with strong positive unit economics and operating leverage will be most attractive to growth and public investors. To that end, companies are extremely focused on spending to attract the right customers.

GK: I agree: growth will always be critical for tech and specifically internet investors. And to Cameron’s point, today’s focus is on targeting higher-value customers and growing LTVs, which will really drive positive unit economics and operating leverage.

Q: Are companies facing similar challenges retaining customers and preventing churn?

Covid had an interesting impact on ecommerce. Consumer-facing businesses initially benefited from the pandemic, as the internet became everyone’s window to the world and primary platform for interacting with society. Clothes, groceries, electronics, and services were all ordered or consumed online. As consumers re-entered the physical world, growth slowed, as many unsubscribed.

Q: As things continue to normalize following Covid-19, which businesses do you feel have the greatest opportunity in the latter half of 2023 and beyond?

CL: Travel is an intriguing space right now. The industry initially suffered enormously during the pandemic, but as new patterns emerged, businesses began to adapt. Capitalizing on the
popularity of working from new locations and outside cities, Airbnb had a huge resurgence, even without the benefit of international travel. Long-term stays are now Airbnb’s fastest-growing business segment, with more than 70 million Americans poised to adopt a ‘digital nomad’ lifestyle.
Another area that shows a lot of promise is the creator economy. TikTok has shown that even markets previously dominated by big tech can be unexpectedly disrupted by newcomers. Even attempts by established players to replicate TikTok’s formula have been largely unsuccessful. We are all creators, whether through short- or long-form, in written or video format. The next generation is defining market trends, as younger consumers increasingly shop on social media platforms.

GK: As investors evaluate what companies have the best opportunities, they should consider whether the product acceleration that occurred during Covid offers tangible long-term benefits. While online grocery shopping felt like a necessity during the pandemic, we have seen many customers return to grocery stores as daily life normalizes. As a result, online grocery or shopping platforms have seen a pull back. By contrast, streaming platforms and remote work, which also accelerated during the pandemic, are clearly here to stay. Additionally, online health platforms are surging due to increased demand for easy access and our society’s growing prioritization of health.

Q: What do you think will define the next phase of development for private internet and technology companies?

CL: I think there is a growing realization that management teams need to focus earlier on building sustainable businesses, not ‘science projects’. We’ve seen this play out among large tech companies where there have been significant headcount cuts in unprofitable business areas. It’s even more vital for young, private companies to prioritize capital investment. In an environment with a much higher cost of capital, they need to make difficult resource allocation choices to succeed. And this is a tough adjustment for some because we now have an entire generation of founders who have never experienced a major downturn or recessionary environment. However, I don’t see this development as a negative. Operating with limited time and resources often drives efficiency and productivity, enabling focused businesses to flourish under these conditions. What sets the end of this recent bull cycle apart from previous ones, and gives cause for optimism, is that many macro trends are more favorable now than ever before. For every failed business that hasn’t adequately addressed its problem space or efficiently deployed capital, three better-managed businesses will rise to take its place.

GK: Absolutely — in a capital constrained environment, the route to success changes. A few years ago, tech product managers would have emphasized building the best product possible.
Now, the emphasis for product strategy lies in making the product usable, feasible, and viable. If they achieve adoption, they can refine it. What’s fantastic is that, after a tough few years, the ecosystem for private internet and tech companies is increasingly stable and the outlook for growth is very positive.

Why Private Equities Will Outperform Public Equities

It’s an uncertain yet exciting time in the markets. Debates continue about the direction of Fed Funds and interest rates, wage and inflation pressures and the likelihood of a soft vs. hard landing. Despite what some perceive as an exceedingly challenging investing environment, there is ample reason to be bullish about the prospects for the private equity asset class. 

My sponsor colleagues and I had the pleasure of attending several sponsor Annual Meetings over the last few weeks and found several reasons for optimism, four of which we detail below:

A Coming Wave of Corporate Carveouts

The public equity markets will continue to offer excellent investment opportunities for private equity including divestitures, take privates and PIPEs – and corporate carveouts in particular.

As companies across sectors have been forced to right size and down size, it’s becoming clearer which ones have divisions that may be underinvested, with strategies that may not align with the parent or management teams that lack the necessary decision making authority. Carving out these divisions into standalone businesses can be a minefield, as it requires intense work and presents M&A and operational complexity. But corporate carveouts done right also present enormous opportunity, and they have represented some of the best performing investments in private equity.

Private equity is particularly well-suited to lead these carveouts because they often have:

• Expertise in negotiating transition services agreements and identifying excess costs.
• Understanding of the complexities of transitioning accounting, financial and IT systems and building a new culture and corporate identity for the carveout business. 
• Executive and operational experience through senior advisors.
• The capital to support add-ons and new capital projects. 
• The ability to create an exceptionally talented board that can create the right incentives for management.

Growth in Leveraged Loans

Tightening fixed charge coverage ratios will increasingly necessitate corporate deleveraging and require junior capital solutions. A majority of direct lending loans, for example, still have maintenance covenants with cushions that are shrinking. That’s why we are witnessing more credits that will require a capital solution and why we expect more opportunities in the second half of the year.   

Many corporates will turn to private equity for structured junior capital, debt buybacks, maturity extensions, up tiering exchanges and self-help junior capital investments. Private equity is well positioned for many of these opportunities given their fund flexibility, new pockets of capital and recycle provisions allowing for up to three years to recycle capital in many cases.

Family-owned Businesses in Transition

Family-owned businesses represent 55-60% of US GDP and are often small and mid-cap companies being managed by 2^nd and 3^rd generations that are focused on succession and wealth preservation. Many are now seeking capital as part of generational transitions and we expect the trend to accelerate given a more uncertain economic outlook and future tax environment. 

Generational opportunities are not listed in any database and require extensive relationship building. They are fraught with challenges but private equity often represents the best source of capital given many of these companies are not exiting via the IPO market given their small and mid cap size. 

This is an area where private equity has an excellent history of great returns and generating far greater wealth for families that roll their equity stake. 

Jefferies has been leveraging our firmwide footprint in many local markets and deep banking domain expertise to identify family-owned businesses and curate introductions within the private equity community. We host ten private company summits each year across many industry verticals and sub verticals and these venues have historically been an excellent forum for family owned businesses to meet several private equity firms and start building a longer term relationship given the importance of finding a “right partner.”

Data and Digital Technology Driving Operational Improvements:

Private equity is often intensely focused on operational improvements at their portfolio companies and has several tools to deploy across an entire portfolio of companies ranging from talent management and recruitment to procurement and other scale advantages. More recently, they have focused on two additional strategies – data analytics and digital technology – to transform businesses. Many private equity firms are finding great success leveraging data to:

Many private equity firms are finding great success leveraging data to:  

• Generate incremental revenue streams. Sponsor portfolio companies have vast amounts of data and are starting to hire internal and external teams to help monetize it. 
• Source and conduct diligence on new investment opportunities.
• Assess their portfolio company’s suppliers, customers, new entrants and leveraging this data to acquire a new standalone platform in an adjacent market.

Although many investors are approaching this investing environment with caution, private equity is adapting with more tools and more creative methods to unlock value and create superior returns for their LPs.  In short, we believe the latest vintage of PE funds will exceed expectations and continue to outperform public equities.

Jeff Greenip is a Managing Director and Global Head of the Financial Sponsors Group. Jeff joined Jefferies in 2008 after holding senior positions at Bear, Stearns & Co. Inc. including Co-Head of Global High Yield Syndicate. Jeff has an MBA from Columbia and a BS from Georgetown University’s School of Foreign Service.

Robert Eccles & Daniel Crowley: Rescuing ESG from the Culture Wars

Aniket Shah, Global Head of Environmental, Social, and Governance (ESG) and Sustainability Research at Jefferies, recently joined Robert Eccles and Daniel Crowley in a conversation about the political complexities and misconceptions surrounding ESG.

They offer insight into ESG’s unfortunate entanglement in political and cultural battles, addressing common misunderstandings held by both the left and the right. They discuss efforts to bridge political divides, acknowledging the often-overlooked overlap between ESG disclosure and conservative values. The group also expressed optimism for the future of the ESG movement, even if it eventually moves away from the ‘ESG’ moniker.

Robert Eccles is among the world’s foremost experts on integrated ESG reporting. He is the Founding Chairman of the Sustainability Accounting Standards Board and a former Professor of Management Practice at Harvard Business School.

Daniel Crowley is a partner in the Washington, DC office of K&L Gates LLP, where he leads the firm’s global financial services policy practice. He previously served as Chief Government Affairs Officer at the Investment Company Institute and Vice President and Managing Director in the Office of Government Relations for NASDAQ.

How are individuals from different political persuasions coming together to advocate for ESG principles?

Crowley: We’re witnessing a power struggle in global politics, and, unfortunately, ESG often gets ensnared in these debates.  

On the one hand, you have political factions on the left and right waging assaults on each other’s policy agendas. On the other, you have a concentrated desire within the investor community for increased transparency related to material risks.

That’s where ESG centers – not in the debates between the far right and far left, but in the investor community’s search for quality information. The more we conflate these issues, the more our public understanding of ESG is diminished.

Eccles: Opposition on the Republican side may be louder, but there’s considerable pushback from the left, too. Progressives claim it’s not ‘true sustainability’ – just another tool for value creation.

Loud, unconstructive groups on both extremes pollute our discourse, but if you look past the political theater, there’s more bipartisan alignment around ESG than one might expect. It’s time for both sides to lower their defenses and engage in productive dialogue around material factors.

Political repercussions – real or imagined – have a significant impact on our clients’ decision making. Can you offer some insight into our heated politics’ effect on the private sector?

Eccles: We meet with a lot of company leaders and asset managers, and despite the political rhetoric, they are continuing to discuss ESG with investors, albeit more quietly.

Some concerns around ESG are self-inflicted, with firms making grandiose claims about saving the world from climate change and inequality. When our conversations are disciplined, they breed consensus. ESG is about distinguishing between material risk factors and positive and negative externalities.

Politically, there’s an important debate to be had about the roles of the public and private sector in our society. On the issue of ESG, though, there remains broad engagement from both sides of the aisle.

Crowley: Today, many House Republicans equate ESG with the Green New Deal. They think it’s the product of an AOC-led ideological movement and view it as a potential threat to our democracy.

It’s important to remember that ESG conversations date back 20 years, at least. We need to take a step back and remember this is a risk issue: when companies aren’t transparent, they get wiped out. We saw this with Enron, WorldCom, and now, Silicon Valley Bank.

Republicans should remember that these are conservative principles. We want free markets to be rooted in an informed assumption of risk. When the right shoots at ESG, they form a circular firing squad, hitting key constituencies in the Republican party: asset managers, brokers, hedge funds.

How is the idea of an ‘ESG fund’ or an ‘ESG stock’ undermining the conversation around ESG?

Eccles: People make the mistake of confounding ESG with impact. ESG integration is about data analysis – it doesn’t inherently make the world a ‘better’ or ‘worse’ place.

An impact fund invests to address societal challenges. These funds could still fall short on ESG practices in their operational strategies! Socially responsible investing is important, but these labels muddle the public discourse around ESG, and we need to distance ourselves from them.

Crowley: Another issue is the narrow interpretation of ESG’s components. In Washington, DC, ‘E’ has become synonymous with climate change, ‘S’ with human capital, and ‘G’ with proxy voting. People don’t appreciate the scope of ESG analysis.

These concepts are much broader than they’re often treated by our elected officials. The current dialogue no longer represents the foundation of ESG, which is managing enterprises for long-term value creation.

If you were to emphasize one or two key points to ESG skeptics on both the right and the left, in a bid to find common ground, what would those be?

Eccles: If I’m talking to someone who claims not to like ‘ESG,’ I’ll tell them I don’t like ESG either!

I like material risk factors. I like addressing externalities. I won’t try to dissuade you from disliking ESG; I’ll just recenter the conversation around managing risk and equipping investors with quality data. Then, we have plenty to discuss.

Crowley: Many on the left call for increasingly detailed disclosures, regardless of their financial materiality. The truth is that disclosure, alone, can’t move the needle on climate change.

If we hope to tackle climate change, we need to leverage macroeconomic forces. Concentrate on implementing measures like a carbon tax. As these policies take effect, they’ll enhance the relevance of ESG materiality, allowing the goals of ESG proponents and climate activists to advance in unison.

Digital Health: Below the Surface

Digital health is the latest healthcare theme capturing investors’ attention. Data breakthroughs in life sciences have been around for decades (Think: CRISPR DNA editing), but our healthcare systems are going through a complete digital transformation in the wake of Covid-19. Digital Health: Below the Surface, unpacks the digital health universe, the institutional investor landscape, and how this area differs from other sub-sectors in life sciences.

Normalcy Returns Faster Than You’d Think After Financial Crises

APRIL 2023

Dear Clients, Jefferies Employee-Partners, and Friends,

With the end of the first calendar quarter of 2023 complete, once again the financial world feels “on fire.” Interest rates are still rising, inflation remains unchecked, two top 20 U.S. banks were put into receivership and auctioned off, and we just witnessed an emergency “shotgun wedding” to protect the world from the imminent demise of a systemically critical global bank. The financial news is dominated by discussions about asset/liability mismatches due to rapidly rising interest rates and the resulting mark to market losses, protecting consumer deposits above the federally mandated $250,000, and which large bank could be next to stumble. It is almost enough to make one forget that there is a European war going on “real time.” Though we can NEVER FORGET the Ukrainian war because the unprovoked attack on innocent people makes the financial calamity pale in comparison, but you get our point.

So how do all of us put this new financial crisis into perspective as we focus on our day-to-day responsibilities as we manage our businesses, investment portfolios, co-workers, families and friends? It is very easy to get sucked into the abyss and focus on the day-to-day minutiae of putting out fires caused by the second and third level effects that emanate from the serious financial issues we have just mentioned. In times like these, nothing enables us to see the big picture better than stepping back from the immediate fires (yes, we still need to put them out hourly) and taking a look at the very big picture over a widely extended time horizon.

For that reason, we prepared the slide below that shows the periods of economic and market challenge the two of us have experienced these past three plus decades:

Some observations from this smorgasbord of turmoil:

1. Our world always finds a way forward. In fact, things are usually pretty darn good in a surprisingly short period of time after we avoid often anticipated the “end of the world.”
2. Government intervention, while never ideal or desired, can help solve very complicated and broad problems. The goal, though, should be to make much-needed changes in regulation, incentives and culture throughout our system during periods of relative calm to avoid/minimize future problems and reactive intervention.
3. People or institutions that do not have a strong foundation, constitution or character can easily be wiped out at the bottom of the cycle. This has broad implications why the right culture, capital structure, temperament and ego during good times (which always precede bad times) is so important.
4. People or institutions that panic, freeze or flee when times are at their darkest deprive themselves of participating when the sun comes out once again.
5. People or institutions that buckle up, put out the fires, remain calm, encourage their partners to do the same, and stay the course even when it feels like there is no reason or reward to keep marching on, are often the ones who get magnified positive results when the storm passes.
6. The smart, well-fortified, pre-prepared, and forward-looking people or institutions that have the luxury and nerve to play offense during these especially turbulent times can find themselves at another higher level (in almost every aspect) when the sun shines again, if they play their cards properly.
7. The reason why people or institutions who focus on the long term versus the short term always win is because this roller coaster never ends. The twists and turns and ups and downs may always look and feel completely different, but when you step back and look from a distance, there are enough patterns and similarities that will help thoughtful minds make sense of it all.

When we look back at these past three and a half decades at Jefferies, we marvel at our corporate and investing clients who have best navigated the storms along the way. We have seen (and hopefully helped) corporate and private equity clients build amazing world class companies, consolidate industries and create enormous economic and social value. We have seen (and hopefully helped) our investing clients generate exceptional long-term, alpha-based returns for their shareholders and even build large, multi-faceted asset management platforms. Both groups of clients have driven change and created positive economic and social benefits for our society.

That said, having lived through so many financial crises, we are acutely aware of the pain and serious ramifications each one has caused, particularly the hardship of losing a job, a beloved firm you’ve given a large part of your life to, and the often gut-wrenching personal and societal economic impact that follows. Today is one of those times. But while extremely unsettling and painful (especially to those directly affected), we do not believe the current financial situation compares in systemic magnitude to the other crises we’ve witnessed and are included in our chart.

To us, the salient takeaway is when we look back at this chart and combine it with our intimate knowledge of our vibrant and impressive client base, it is apparent which characteristics the most successful individuals and companies share. They are all consistent year in and year out. They have a strong foundation both in capital and culture. They share the gift of zero arrogance and while they keenly embrace their current reality, they also have the gift of being able to anticipate change. They strike the right balance of patience and aggressiveness while remaining calm regardless of circumstances. None of them ever give up, and while they all share a keen sense of urgency, they all prioritize the long term.

We at Jefferies always strive to do the same, and we humbly admit that it is not always easy to do so. We clearly make a lot of mistakes, but on balance our partnership with each of you allows us to minimize them, and stick to what we most enjoy:

Working to build value with all of you by focusing on the long term, regardless of the current climate, crisis or calamity.

Once again in the bunker with each of you, but enjoying every moment as we persevere and continue to build together, and knowing that we will all come out together on the other side, sooner than we might expect,

Rich and Brian

Prime Services C-Suite Newsletter – April 2023

Springing into SEC Proposals, Travel, Digital Health, and Talent

Our monthly newsletter for multi-hat-wearing C-suite leaders covers the latest and greatest insights across the hedge fund industry.

Uncertainty & the Value Proposition of Hedge Funds

In 2022, hedge funds had their best year of outperformance in over a decade. Investors are curious how hedge funds will navigate further volatility, uncertainty, and unexpected market events. The Value Proposition for Allocations to Hedge Funds investigates how managers have outperformed during market turbulence and what role they may play in allocators’ portfolios in the year ahead.