Is there a bubble brewing in the buyout business?
With investors and executives flocking to private equity, it's not just the money pouring into leveraged buyouts that's soaring, or the returns funds are pulling out. Deal prices and leverage are skyrocketing, too. And that has even some seasoned private-equity executives starting to worry that funds are overpaying on deals and loading companies up with too much debt, sowing the seeds of a big rise in defaults. "If this were emerging-market debt, at these numbers no one would touch it," says one fund manager.
Consider some recent deals. To beat out Carl Icahn for luxury chain Fairmont Hotels & Resorts Inc. (FHR), Los Angeles investment firm Colony Capital LLC and Saudi Prince Alwaleed bin Talal's Kingdom Hotels International agreed in late January to pay $3.3 billion and assume an additional $500 million in debt -- roughly 21 times earnings before income taxes, depreciation, and amortization (EBITDA) in 2004. Meanwhile, earlier in the month, a group of buyout firms paid 12.8 times EBITDA for Dunkin' Brands Inc., well over the 7 to 8 times typically paid in the restaurant industry. Marvels Tom Marshella, a managing director in leveraged finance for credit-ratings agency Moody's Corp. (MCO): "Those are just extraordinary multiples."
Leverage has also ticked up sharply. In the average deal from 2000 through 2002, companies took on debt equal to four times EBITDA. By the end of 2005 that number had crept up to over 5.6, according to Standard & Poor's LCD unit, which tracks the leveraged loan market. "There's a massive amount of liquidity available, and right now lenders are not being conservative about holding the line," says LCD director Chris Donnelly.
So far they haven't had to worry. Junk-bond defaults, at just 1.9% in 2005, remain well below the long-term average of around 5%, according to Moody's. Buyout executives say the higher prices and debt levels are easily supported by the faster growth and stronger earnings they achieve. "If we execute against our plans, we improve operations and generate a lot of free cash flow that can go to pay down debt," says Scott M. Sperling, co-president of Thomas H. Lee Partners LP. At Dunkin', for example, greater expansion of the fast-growing coffee and donut chain beyond its Northeast base is planned, while Colony Capital expects big gains in cash flow at Fairmont thanks to recent renovations. A spokesman also adds that the deal is cheap judged by the price paid per room rather than EBITDA multiples.
The question is, what will happen if the economy slows, interest rates climb sharply, or buyout firms stumble in boosting growth or cutting costs? "Some of these deals are priced to perfection," says Michael H. Anderson, U.S. high-yield strategist for Lehman Brothers Inc. (LEH) "They'll need a strong economy, and management will have to execute perfectly to survive."
If they don't, this buyout boom could go bust, leaving a pile of junk-rated companies, defaulted debt, and lost equity in its wake. That's likely to remain a while off, probably no sooner than 2008, says Martin Fridson, CEO of high-yield bond-market strategist FridsonVision LLC. But with credit quality sharply deteriorating, he expects default rates to climb back to peak levels. The good times, in other words, won't last forever.
By Jane Sasseen, with David Henry, in New York