A Worrying Trend In The High Yield Market

WeWork is a fascinating – and worrying – beast.

From nowhere, the company has grown into a global outfit with locations around the world where individuals and companies can rent office space on a pay-as-you-go basis.

This has been achieved through a series of huge equity fundraises, including a mammoth $4.4 billion injection from SoftBank in 2017, which valued the company at $20 billion. But WeWork’s reliance on equity funding at sky-high valuations has invited awkward questions from some commentators regarding the sustainability of its business model.

Against this backdrop, the company recently made its US Dollar market debut with a $702 million 7-year bond issue, priced at a yield of 7.875%. The blowout transaction grabbed headlines when it was upsized from an initial target of $500 million, and it grabbed them again for the wrong reasons when it underperformed in the secondary market. In its first week of trading, the deal has bombed, dropping in price by close to 5 points in a move politely described by analysts as, “unusually poor performance for a newly issued high-yield note.”

A reaction piece in the FT (which has been sceptical of the company’s fundamentals for a while) cited concerns amongst investors regarding WeWork’s underlying “asset-light” business model. Renting office space on long leases and charging members for access on the monthly basis seems to flunk ALM 101 and expose the company to great risks, both in terms of falling real estate rates exposing them to competition, and short-term reductions in demand from customers seeking to cut costs. Everything looks good right now, but an economic downturn could wreak havoc. Truth be told, bond investors are fundamentally sceptical of asset-light businesses, and WeWork is certainly one of those. They like recourse to fat, juicy assets in case of default.

The divergent assessments of different ratings agencies on the deal (with Moody’s rating the notes at Caa1, Fitch rating it four levels higher at BB-, and S&P rating it one notch below at B+) have also raised eyebrows. They simply voice what everybody’s thinking and  confirm we’re in uncharted territory with this new breed of high yield transactions. In recent months we’ve seen Tesla, Uber and Netflix hit the market, and should expect more in 2018.

What to make of all this? Eventually all companies (even the highest flying startups) need to construct and validate business models in order to build sustainable businesses. The venture capital and private equity markets have matured and deepened substantially in recent years, allowing companies like WeWork to raise huge amounts of private money to invest in growth. In other words, they’re burning through cash in order to buy market share. Access to private markets also enables unicorns to delay their day of reckoning, when their equity valuations become too high and they have to turn to public markets.

The bond market, for all its shortcomings, is grounded on basic financial concepts, such as cash flow, interest coverage and asset coverage. These might not be trendy or exciting, but they are proven methods for assessing the risks and rewards of investing in companies. If the venture market dries up, unicorns shouldn’t expect the bond market to come to their rescue, especially if they haven’t yet figured out a way to break even.

Bond investors are only going to get more savvy as rates rise and the desperate need to invest dissipates. A perfect storm is brewing up ahead and for some of the world’s biggest private companies, it might be too late to change course.