The messy market in risky mortgages has made banks much less willing to hand out no-money-down loans or to put cash in the hands of unqualified buyers. But look beyond the subprime problems, and you'll see that the market for shaky corporate debt also has some difficulties just now coming to light. And they may prove to be even more severe.
Far from some esoteric niche of high finance, the new caution around syndicated debt holds immediate ramifications for investors. If a major transaction such as the $29 billion deal for First Data (FDC) or Chrysler's complex go-private acquisition were to collapse, the repercussions on Wall Street would be immense and far-reaching.
Who's Left Holding the Bag
"If one of these big chunky deals that are coming up gets hung, it could put underwriters out of the market for a while," says Steven Miller, head of Standard & Poor's Leveraged Commentary & Data. (S&P, like BusinessWeek, is a unit of the McGraw-Hill Companies (MHP)). If it becomes more difficult for private equity firms to obtain cheap financing, the record pace and price of leveraged buyouts is likely to slow. That in turn could curb prices in the stock market, which have been driven in part by the expectation that many public companies will be taken private at a rich premium.
Just three months ago, investors appeared ready to buy just about anything the bank-loan or junk-bond market could manufacture. But over the past few weeks, investment banks have found themselves unable to sell loans that were designed to fund risky LBOs. As a result, investment banks have been left holding the debt, without others to share the risk (see BusinessWeek.com, 7/10/07, "End of the Private Equity Party?").
"The question is whether investment banks will be able to find a home for the loans that they are committed to or whether they will have to swallow all that debt. We will have a better idea of how the market shapes up after a few weeks," says financier Wilbur Ross. "Some riskier deals that don't have committed financing might not get done" (see BusinessWeek.com, 5/15/07, "Wilbur Ross: 'No Chapter 11 Here'").
Investors Balk at Toggle Notes
So far, the investor backlash has been limited to smaller and midsize deals that employ some of the particularly aggressive financing structures. Investors have soured on deals that rely on so-called toggle notes, which allow a troubled borrower to repay one loan by borrowing more money from another source.
Private equity firm Clayton, Dubilier & Rice has had trouble financing its $7.1 billion buyout of U.S. Foodservice. The Columbia (Md.) company had to scale back a proposed $1.1 billion junk bond deal to $650 million. It also had to shelve plans to syndicate a $3.3 billion loan with toggle notes. That has left banks such as Citigroup (C) and JPMorgan Chase (JPM) responsible and holding all the debt—a position the banks hardly want to be in. Clayton also had to cancel plans for one of the bank loans designed to finance its $5.5 billion takeover of lawn-care company ServiceMaster (SVM) after debt investors balked at the toggle notes.
Cerberus and KKR Deals Could Stall
The question now is whether the investor rebellion will spread to larger loans designed to finance mega-cap buyouts. The market will soon face several major tests. The next big offering on deck is Cerberus Capital Management's buyout of DaimlerChrysler's (DCX) Chrysler Group unit. That deal includes $20 billion in loans.
Kohlberg Kravis Roberts also plans $14 billion in loans to help finance its $29 billion takeover of First Data. The offering was originally scheduled for late July, but is now expected in September. Investors are leery of the deal's use of toggle notes. TPG Group's $45 billion buyout of Dallas-based utility TXU (TXU) could be another major test of the debt market, although the timing of that offering is unclear. It's expected to be worth $10 billion or more, though.
Cerberus faces intense scrutiny over Chrysler, if only because of the numbers involved. It is trying to raise $12 billion for the Chrysler auto business and $8 billion for its finance business. However, the loans are structured in a conventional way and don't make use of toggle notes, market observers say.
Collateralized Debt Is a Good Deal
One mutual fund manager says he's willing to invest in the deal. "I would love to own Chrysler. It's a chance to lend to a company on a senior, secured basis," says Payson Swaffield, managing director at mutual fund company Eaton Vance. "Seven or eight years ago, when the company had an investment-grade rating, it wasn't obligated to put up collateral for its loans, and I wouldn't have looked at it. Now, with a speculative rating, it must put up collateral, and it's a wonderful opportunity. I don't have to bet on a turnaround at Chrysler, either. All I am betting on is that I will get repaid and that I will get a good yield."
Even if the deal goes through, it may reflect some subtle changes in price or structure that will make it different from what the market would have accepted last spring.
"There is going to be an ongoing negotiation between equity and debt, and there may need to be adjustments to the structure and price of deals. But private equity funds are very, very good at working flexibly within those constraints and finding common ground to get deals done," says Monte Brem, CEO of private equity consultant and asset manager StepStone Group. "The terms of deals may not be as attractive for the equity as they were a month and a half ago, but the equity funds and debt providers will likely find a middle ground that allows them to get deals done on terms they both find acceptable."
First Data Deal Is on Shakier Ground
First Data could be a bigger test, though. The buyout is supposed to be financed with $14 billion in loans, sold mostly to hedge funds and other institutional investors. The loan includes few covenants, which are rules that allow note holders to call their loan if the company fails to operate within certain boundaries. The First Data buyout also would be financed with $7.5 billion in junk bonds, including $2.5 billion in toggle notes, one market analyst said. The market also will be watching to see whether investors can absorb all of the debt from the $27.5 billion buyout of Alltel (AT) by Goldman Sachs (GS) and TPG.
Market conditions can change radically in just a few weeks. It's possible conditions will improve as some of the larger deals are syndicated. Then again, an inflation scare or hedge fund bust could make investors even more skittish—and then the private equity party really could be over.