In an unstable economy, bond payment failures take on added import as bellwethers of ailing markets.
Especially when they involve large, well-known corporations.
On December 15, Caesars Entertainment Operating Co. Inc. (Nasdaq: CZR) failed to make a $225 million interest payment on its 10% Second Lien Notes due 2018.
CZR has a 30-day grace period to make the payment or be declared in default.
On Friday, December 12, it was reported that negotiations with senior creditors regarding a debt restructuring had broken down.
This comes as no surprise to those of us who have been watching one of the ugliest situations in the debt markets unfold over the past couple of years.
But it does reveal a surprising buying opportunity...
Meet the Private Equity "Sponsors" Stripping Caesars Clean
Indeed, the entire situation and the players involved deserve particular scorn as this sham transaction has unfolded.
Asset stripping, equity dilution, and $4 billion in corporate value that's disappeared are just small parts of the story.
What's happening now is the start of an endgame that will leave you shaking your head, and thankful if you were not one of the investors who stands to lose money...
On November 25, UMB Bank, the Trustee for Caesars Entertainment Operating Co. Inc.'s 8.5% Senior Secured Notes due 2020, filed a devastating lawsuit against Caesars Entertainment Corporation, affiliated companies, and the companies' directors and officers.
The lawsuit is an attempt to salvage one of the most ill-begotten leveraged buyouts in history, and at the same time a comprehensive and powerful indictment of a scheme perpetrated by Caesar's private equity owners, Apollo Global Management LLC (NYSE: APO) and the "Sponsors," Texas Pacific Group (TPG).
It catalogues over $4 billion of value that has been shifted away from Caesars Entertainment Operating Company to two other entities under the control of the Sponsors, Caesars Growth Partners, LLC, and Caesar Acquisition Company.
By all accounts, this effort has been led by Apollo, which has managed to build a formidable investment firm after almost collapsing during the financial crisis and then managing to recover despite a history of mistreating creditors in its private equity deals and being widely distrusted on Wall Street.
The lawsuit was masterfully drafted by a skilled team of lawyers led by the firm Quinn Emanuel Urquhart & Sullivan, LLP, a firm I have some experience with and know to be extremely formidable litigators. Apollo is conducting itself as though this lawsuit does not pose a threat to its business and reputation, but it is sorely mistaken.
The thoroughness with which the Sponsors have looted Caesars over the past couple of years can only be described as deliberate, pathological, and potentially criminal; a vulture could not have done a better job picking the corpse of CEOC clean.
The Sponsors' behavior includes all of the hallmarks of a desperate borrower, including transparent attempts to avoid both the plain language and clear spirit of indentures as well as transactions approved by conflicted directors and blessed by hired gun lawyers and investment bankers issuing phony fairness opinions.
One has to marvel at the gall of Apollo for thinking that anyone would be fooled by antics that wouldn't fool a five-year old child and don't stand a chance of fooling a federal bankruptcy judge.
Some of the most powerful investors on Wall Street are challenging the Sponsors' actions and are unlikely to go away quietly as the UMB Bank lawsuit clearly suggests.
Indeed, this all could've been avoided had the Sponsors engaged in even a modicum of good corporate behavior...
Following the Lack of Moral and Ethical Behavior
What is particularly unfortunate is that there was no need for the Sponsors to behave this way; they had every opportunity to work with creditors to constructively address the company's debt problems.
They also have the financial and intellectual resources to solve Caesars' problems but instead have resorted to a course of action that exposes their principals and shareholders to serious liability. The proper course of conduct would have been to initiate a series of debt-for-equity swaps a couple of years ago, but that would have diluted the Sponsors' multibillion dollar investment in the company.
Since that investment has been worthless since virtually the day they grossly overpaid for the company, debt-for-equity exchanges would have begun the necessary deleveraging process that by now could have significantly improved Caesars' prospects.
One of the most disappointing aspects of Wall Street and Washington, D.C., today is an absence of wise men who have the moral authority to inspire and enforce good behavior. This was obvious in the period leading up the financial crisis when the men (they were all men) running the largest investment and commercial banks engaged in gross acts of mismanagement.
Despite all the bold talk of reform and thousands of pages of new laws and regulations, there is a crippling moral vacuum among the so-called elite of our business and political worlds that allows unacceptable behavior to be dismissed as "business as usual." Bad behavior will continue to persist as long as it is tolerated by the business community. Lawsuits are not enough. Bad actors need to be ostracized by their peers even more than by the government.
In the Caesars case, the Sponsors' behavior has damaged the high-yield bond market because it leads bondholders to distrust the language of contracts and the motivations of borrowers. The Sponsors have significant strategic partnerships with some of the largest pension funds in the world including CALPERS and Texas Teachers Retirement System.
Those institutions should be extremely uncomfortable with the Sponsors' conduct; experience strongly suggests that people who engage in bad conduct don't discriminate among their victims and rarely end up sparing their partners.
In fact, the closer one is, the more likely one is to be victimized and the only question is when.
Apollo recently held its first investor day at which it discussed its business and plans for the future. Press reports made no mention of whether the firm's principals were asked about Caesars or how their behavior in that case might affect their future prospects.
The Caesars case is not the first time the firm's conduct has been called into question; several years ago it was forced to settle an ugly lawsuit by Huntsman Chemical that questioned its ethics.
There were also recent reports that Apollo was going to be the high bidder for a leveraged buyout (LBO) of PetSmart Inc. (Nasdaq: PETM) in the year's biggest LBO, until it was outbid earlier this week by a consortium controlled by BC Partners.
One can only wonder whether major investors in the high-yield market would have been willing to finance a new LBO for Apollo in view of Apollo's treatment of Caesars' creditors.
Of course, Apollo may have sufficient funds under management in its own credit funds to finance such a deal itself. That is a good thing. That way, if one of its portfolio companies runs into trouble in the future, Apollo has only itself to turn to.
The only good news is that savvy investors can find a way to profit amid the turmoil...
This Is the Only Profit Play Left
From an investment standpoint, investors should avoid APO stock and CZR stock and buy CZR's 10% Second Lien Notes due 2018. These are the bonds on which the company missed a December 15 interest payment.
APO stock is likely to come under pressure due to deteriorating market conditions as well as due to the reputational damage caused by its treatment of Caesars' creditors. CZR stock is likely to drop when the company files for bankruptcy sometime in the near future.
In the long-term, CZR stock should rise significantly in value as the company deleverages through a series of debt-for-equity swaps, but it will decline first.
The Second Lien Notes are trading in the mid-teens and will be swapped for equity in a restructuring and should be worth significantly more than their current trading value although this is a long-term trade.
If APO can be convinced to do the right thing and reach an agreement with CZR's creditors that restructures the company through a debt-for-equity swap, the Second Lien Notes could recover more quickly.
About the Author
Prominent money manager. Has built top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.