Dell Lifts Default Risk on Next Buyout Targets: Credit Markets
Derivatives traders are beginning to speculate that the potential leveraged buyout of computer maker Dell Inc. (DELL) marks the return of credit-busting takeovers as the cost of financing the deals gets ever cheaper.
The cost to protect against losses on Quest Diagnostics Inc. (DGX) bonds reached a 15-month high yesterday and Nabors Industries Ltd. (NBR) credit-default swaps jumped to the most since July amid speculation they may become targets for leveraged buyouts. A benchmark gauge of U.S. corporate credit risk rose on the speculation, according to Bank of America Merrill Lynch credit strategists.
Record-low borrowing costs in the market for junk bonds, where LBOs are financed, is combining with rising confidence in the financial system to boost bets that a successful Dell deal will be followed by others. Private-equity funds have $360 billion of committed unspent capital dedicated to buyout funds in the global market, according to data from London-based research firm Preqin Ltd., providing plenty of firepower for more LBOs.
“It’s really now that, for the first time, uncertainty has declined so much that private equity firms have the confidence to pull off LBO deals,” Bank of America Merrill Lynch credit strategist Hans Mikkelsen said in a telephone interview. LBO risk is one of his “big themes” for the first half of this year, “because there’s now a window of opportunity before interest rates increase for these deals,” he said.
“It’s sort of all coming together now: declining uncertainty and banks are ready to fund, and the market is wide open, and interest rates are extremely low,” said Mikkelsen, who is based in New York.
Dell, the third-biggest maker of personal computers, is edging toward an LBO with Silver Lake Management LLC, and Microsoft Corp. (MSFT) is planning to provide part of the funding, people with knowledge of the matter said. Chairman and Chief Executive Officer Michael Dell, the top shareholder in the computer company that has a market value of $22.6 billion, would roll his stake into the buyout, a person with knowledge of the matter said.
Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. fell. The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark used to hedge against losses or to speculate on creditworthiness, decreased 1.6 basis points to a mid-price of 84.9 basis points as of 11:30 a.m. in New York, according to prices compiled by Bloomberg.
The measure typically falls as investor confidence improves and rises as it deteriorates. The contracts pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
The U.S. two-year interest-rate swap spread, a measure of debt-market stress, increased 1.07 basis points to 16.44 basis points as of 11:31 a.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as company debentures.
Bonds of Charlotte, North Carolina-based Bank of America Corp. are the most active dollar-denominated corporate securities today, accounting for 5.7 percent of the volume of dealer trades of $1 million or more as of 11:31 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Credit-default swaps on Dell were the ninth most traded contracts among 1,000 tracked by the Depository Trust & Clearing Corp. in the week through Jan. 18, up from 71st place the week before. Swaps covered a daily average of $300 million of the company’s debt, compared with an average of $100 million over the past month, DTCC data show.
A Dell buyout doesn’t signal the return of multi-billion dollar private equity deals, according to Blackstone Group LP (BX) Chief Executive Officer Stephen Schwarzman. The Dell deal, which Blackstone didn’t consider joining because the PC business “is a tough road,” has a “pretty unique set of circumstances with a fundamentally unleveraged company with an owner and founder that can put up a lot of the equity to make the deal happen,” Schwarzman said in a Bloomberg Television interview with Erik Schatzker at the World Economic Forum in Davos, Switzerland.
Blackstone, the New York-based alternative-asset manager that oversees $205 billion, invested about $4 billion out of its $16 billion leveraged-buyout fund last year, he said. The private equity business, in which funds seek to improve performance at the companies they acquire or expand them before selling them within five years, “has a reasonable level of activity,” Schwarzman said. “The deals aren’t as big, but there are plenty of interesting opportunities.”
Loan prices have risen to 97.72 cents on the dollar, the highest since July 2007, from 59 cents in December 2008, as concern eases that the world’s largest economy will slide back into recession. Leveraged loans and high-yield, high-risk bonds are rated below Baa3 at Moody’s Investors Service and lower than BBB- at S&P.
Issuance of collateralized loan obligations, which group high-yield, high-risk loans and slice them into securities of varying risk and return, peaked in 2007, pooling about $105 billion to invest in junk-grade loans, according to Wells Fargo & Co., which estimates that as much as $80 billion could be raised this year. That would surpass the $55 billion of new CLOs in 2012, which topped the bank’s original forecast for just $12 billion in 2012.
Investors have funneled cash into junk bonds at a record pace, pushed into higher-risk assets as the Federal Reserve holds benchmark interest rates between zero and 0.25 percent and buys back bonds to suppress borrowing costs.
Companies issued $359 billion of U.S. high-yield debt last year, with yields touching a record low 6.42 percent yesterday. Banks arranged $638 billion of leveraged loans last year, compared with $592 billion in 2011, Bloomberg data show.
Strong demand for debt and low borrowing costs will lure would-be acquirers who need to put money to work, according to Marty Fridson, the chief executive officer of FridsonVision LLC, who began trading corporate debt in 1976.
“Once you raise a $10 billion fund, you don’t want to give it back because you can’t find deals to do, so the tendency is to rationalize, justify deals that are now very competitive,” Fridson said.
There will be about $135 billion in LBO volume this year, compared with an average of $100 billion during the past two years, and below the $600 billion annual peak of 2006 and 2007, he said.
Credit-default swaps typically surge on LBO speculation because the debt added to a company’s balance sheet to fund the takeover erodes its credit quality and leads to ratings downgrades.
“As the recent experience with Dell illustrates, the risk of LBOs has a particularly large impact” on Markit’s investment-grade benchmark, pushing it a net 2 basis points wider, Bank of America’s Mikkelsen and Yuriy Shchuchinov wrote in a Jan. 23 note. Their model shows 14 percent of the index’s underlying credits are feasible LBO candidates.
Credit-default swaps on Quest Diagnostics have climbed 38.5 basis points to a mid-price of 123 basis points since Bloomberg News first reported Dell’s buyout discussions with private- equity firms, according to data provider CMA, which is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the privately negotiated market.
That was “precipitated by investors’ buying protection on names that have traditionally been considered LBO candidates,” following the Dell news, according to at note dated Jan. 23 from Barclays Plc analysts led by Shubhomoy Mukherjee.
Credit-default swaps tied to Nabors surged 42 basis points to 191, the highest since July, and contracts on Avnet Inc.’s debt climbed as high as 254 basis points on Jan. 14 before falling to 178 basis points yesterday, CMA data show. Those on Falls Church, Virginia-based Computer Sciences Corp. (CSC) added 40.5 basis points since Jan. 11 to 193 yesterday.
Buyout firms announced a record $1.6 trillion of acquisitions from 2005 to 2007. The end of that era was “quite painful for many overleveraged deals and many PE firms and their investors have continued their long wait to reach that point where they can exit and take their gains,” CreditSights Inc. analysts Glenn Reynolds and Ping Zhao wrote in a note.
The size of the Dell transaction means “all of a sudden the theory that the next LBO cycle will have a more restrained and manageable deal size with less HG bondholder damage will be justifiably questioned,” they wrote in the Jan. 20 note titled “LBO Risk Revisited for HG Bonds.”
“The deal raises the bar on average deal size and opens up a world of competitive pressure for other private equity firms and banks in a business that begs a ‘me too’ response.”
LBOs bigger than $20 billion are difficult to make profitably and the track record of such deals hasn’t been good, according to David Rubenstein, co-chief executive officer of Carlyle Group LP. (CG)
“Large buyouts might work, but this history of buyouts with $20 billion or more price tags has not been filled with a lot of success,” he said yesterday in an interview with Schatzker. “You’ve got to work very hard to make those deals work, and good luck to them if they pull it off.”
While Barclays strategists including Ryan Preclaw don’t expect an LBO boom, “credit markets can certainly bear a deal in the $20 billion range of a Dell LBO, but practical constraints on private equity firms are likely to put the upper limit on the total number” of deals bigger than $10 billion, they wrote in a Jan. 18 note.
Total LBO enterprise value will reach at most $75 billion this year, with more deals in the $1 billion to $2 billion range, including smaller units spun out rather than full-scale company purchases, Preclaw said in a telephone interview.
Preclaw expects LBO volume to run at a “normal rate,” rebounding from 2008 and 2009, he said. “There will be deals, but you shouldn’t expect them to be so many that they really start to overload the market.”
Any company with cash on its balance sheet, little debt, real estate, a known brand, and a sagging stock, will “be in the LBO conversation,” according to Robert Smalley, a credit strategist at UBS Securities LLC in New York.
Investors are “yield-starved, and banks are willing to lend, so that spells more higher-yielding transactions,” he said in a telephone interview. “The volume’s definitely been turned up.”
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