At an earnings call in April, an analyst pressed bank CEO Ken Moelis on his rosy outlook for his firm’s restructuring business — the corner of Wall Street known for advising companies with messy books veering toward bankruptcy.
For a healthy chunk of his opening commentary, the namesake founder and CEO of independent investment bank Moelis & Co. touted his firm’s “market-leading restructuring business” for supplying meaningful activity.
“Your comments were surprisingly positive,” said Ken Worthington, a senior equity analyst with JPMorgan Chase. “Is this sort of steady state for you in a lousy environment? Can things only get better from here?”
On the surface, market conditions are showing few signs of distress. The economies in the US and throughout the developed world are growing, the stock market has been upbeat despite fits of volatility, and corporate default rates remain low and are projected to fall further in 2018 and beyond.
So why was Moelis so optimistic about his restructuring team?
“Look, it could get worse. I guess nobody could default,” Moelis said. (Keep in mind that “worse” from the perspective of a restructuring banker, who feasts during recessions, means “better” for most of the rest of the world). “But I think between 1% and 0% defaults and 1% and 5% defaults, I would bet we hit 5% before we hit 0%.”
The billionaire dealmaker isn’t alone in his sentiment. Many on Wall Street are scrutinizing cracks in the economy’s glossy veneer.
JPMorgan copresident and investmen banking head Daniel Pinto told Business Insider in March that a 40% correction, triggered by inflation and rising interest rates, could be looming on the horizon.
The market’s biggest money managers are already positioning as if a major economic downturn is near, according to research this month from Bank of America Merrill Lynch.
And while they’re quick to note that no one can predict the next collapse, Wall Street’s top restructuring bankers are also joining in the chorus cautioning that the economic boom may be on its last legs.
“I do think we’re all feeling like where we were back in 2007,” Bill Derrough, the cohead of recapitalization and restructuring at Moelis & Co., told Business Insider. “There was sort of a smell in the air; there were some crazy deals getting done. You just knew it was a matter of time.”
Business Insider spoke with several top restructuring bankers who were all buoyant on the outlook for their industry, in part because of disconcerting trends facing debt-burdened companies but also because of how the business has changed since the last financial crisis.
Massive debt, rising interest rates, flimsy covenants
The global default rate for weak companies is indeed very low; it climbed in March to 3.9% on the struggles of a handful of retail and oil and gas firms, but it ticked back down to 3% in April and is expected to dip to 1.2% a year from now, according to Moody’s.
But as Moelis alluded to in his investor call, the amount of high-yield corporate debt — bonds and loans issued to riskier companies — doled out in the US in recent years is at levels far exceeding precrisis highs.
Historically, large volumes of high-yield issuance “has led, after a period of time, to an increased level of restructuring,” according to Steve Zelin, head of the restructuring in the Americas at PJT Partners.
Four of the past five years have seen both high-yield bond and leveraged loan issuance that exceeded 2007’s precrisis levels. Further, 2017 was the highest year on record for US leveraged lending, with volume of $1.4 trillion nearly 25% more than the previous high point, in 2013, according to Thomson Reuters data.
“Even if there is not a recession or credit correction, with the sheer volume of issuance there are going to be defaults that take place,” said Neil Augustine, cohead of the restructuring practice at Greenhill & Co.
Granted, the glut of debt is in no small part attributable to the super-low-interest-rate environment imposed by the Federal Reserve following the crisis. Many companies took advantage and refinanced their debt before 2015 when a large swath was set to mature, kicking the can several years down the road.
But going forward “there’s going to be refinancing at significantly higher rates,” Zelin said, given the Fed in March hiked interest rates to the highest level since 2008 and is expected to unleash at least two more hikes in 2018.
Refinancing at higher rates will further shrink the margin of error for troubled companies, as they’ll have to dedicate additional cash flow to cover more expensive interest payments.
“When you have highly leveraged companies and even a modest rise in interest rates, that can result in an increase in restructuring activity,” Irwin Gold, executive chairman at Houlihan Lokey and cofounder of the firm’s restructuring group, said.
And as some bankers said, with investors stretching for yield amid low interest rates, covenant packages on debt deals have grown increasingly flimsy.
But another reason for optimism has to do with how restructuring has changed since the financial crisis. For top firms, it’s become all-weather business in which bankers can earn fees by solving problems and cleaning up balance sheets before a company is teetering upon financial ruin.
“The way restructuring used to work, it was more of an episodic business associated primarily with a spike in default rates,” Gold said. “When you get an environment like 2009, 2010, you’re obviously swimming in opportunities, but we’re quite busy right now and we have been for the last couple of years. We’re always prepared. We’re going after opportunities all the time.”
Part of Moelis & Co.’s strategy involves working with clients before they ever end up in bankruptcy court — arranging debt buybacks and using exchange offers to lessen the debt load and capture discounts. About 50% of its restructuring mandates are completed out of court, according to the firm.
‘There will be a massive amount of work to do’
Still, some firms have been filling out their rosters with talent to be prepared should the economy take a turn for the worse.
“The restructuring business is a good business during normal times and an excellent business during a recessionary environment,” Augustine said. “Ultimately, when a recession or credit correction does happen, there will be a massive amount of work to do on the restructuring side”
Greenhill hired Augustine from Rothschild in March to cohead its restructuring practice. The firm also hired George Mack from Barclays last summer to cohead restructuring. The duo, along with Greenhill vet and fellow cohead Eric Mendelsohn, are building out the firm’s team from a six-person operation to 25 bankers.
Evercore Partners in May hired Gregory Berube, formerly the head of Americas restructuring at Goldman Sachs, as a senior managing director. The firm also poached Roopesh Shah, formerly the chief of Goldman Sachs’ restructuring business, to join its restructuring business in early 2017.
“It feels awfully toppy, so people are looking around and saying, ‘If I need to build a business, we need to go out and hire some talent,'” one headhunter with restructuring expertise told Business Insider.
It’s not exactly a war for talent at this point, though. Firms are primarily adding for junior and mid-level positions, according to the recruiter, who’s noticed job advertisements online and in trade publications for restructuring positions from several large firms.
“Places that don’t traditionally need to advertise in trade rags are popping up,” the recruiter said. Evercore, for instance, has job postings online for restructuring analysts, associates, and vice presidents.
“In our world, people are just anticipating that it’s coming. People are trying to position their teams to be ready for it,” Derrough said. “That was the lesson from last cycle: Better to invest early and have a cohesive team that can do the work right away and maybe be a little bit overstaffed early, so that you can execute for your clients when the music ultimately stops.”
It’s anybody’s guess when that day will come, as nobody has a crystal ball, aside from Ken Moelis, who is said to keep one on a stand in his office that he picked up at a flea market in Paris.
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