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 Hedge fund and distressed specialist James Zenni of Z Capital Partners LLC laid out a fairly bleak economic landscape at a Tuesday luncheon meeting: With the unprecedented level of leveraged buyout activity during the boom, there's "a very large number of untenable capital structures with a tremendous amount of leverage." This suggests a distressed investing opportunity in this cycle that will be unlike previous cycles, he says. Zenni's analysis is based on a confluence of factors: default rates projected to rise as high as 18% this year; a leveraged loan universe that has ballooned to $1.6 trillion; and a high-yield universe that has grown to $930 billion. Including the substantial impending maturities in leveraged loans over the next two years, the total opportunity set is much higher than the $500 billion of debt that may be expected to default based on projections. Zenni is better known as co-founder of Black Diamond Capital Management LLC of Lake Forest, Ill., which acquired controlling stakes in distressed midmarket companies via fulcrum investing. Z Capital, launched in 2006, closed on $100 million in an initial close on a maiden private equity fund. Zenni says signs point to the current recession continuing over the near term, given very high unemployment and underemployment rates, historically low consumer savings rate and households unable to service their debt obligations. The biggest "structural land mine," he says, is the potential unraveling of collateralized loan obligations over the next 12 to 18 months, coinciding with substantial maturities of their underlying assets. CLOs constituted 60% of commitments to new issuances in mid-2007, fueling the rapid growth of the leveraged loan market to $1.6 trillion. Zenni says CLOs are not only ill-equipped to manage restructurings, but any default would trigger a termination of CLO rein-investment periods, which precludes it from participating in refinancing transactions, including debtor-in-possession financing. Given the unprecedented senior leverage levels, Zenni says senior secured debt is substantially more likely than in the last cycle to serve as fulcrum security for investors looking to gain control. Asked whether private equity investors have a role to play in restructurings in companies they own, Zenni wasn't too optimistic:
"That's not what they intended to do, and they're so far out of the money that they'll have to make significant progress through any debt exchanges to make it worth their while. They can provide DIP loans, but any money they make from a DIP may be offset by their losses on the equity side." - Vyvyan Tenorio See related story about CLOs from The Deal magazine
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