In Europe, There's No More Easy Money

Debt holders are getting tougher and savvier

Zurich-based ABB (ABB ) made headlines earlier this year when it harried its former Chairman and CEO Percy Barnevik into returning $53 million of his bloated severance. Meanwhile, it seems, the company itself was almost sleepwalking off a financial cliff. Bankers say ABB's brass didn't see until very late in the game that they were in danger of being locked out of the commercial-paper market. On Mar. 21, with its debt trading at junk levels, ABB hastily drew down a $3 billion backup facility from its banks. But a two-notch downgrade from Moody's Investors Service on Mar. 25 triggered a clause that allows the banks to renegotiate its loans or call them in.

Now the company finds itself in tricky refinancing negotiations with the banks. ABB disputes Moody's negative view and says it is confident of its restructuring plans. But the premium that ABB pays over interbank rates is likely to double, and management is going to be on a much shorter leash. ABB will be forced to sell assets, perhaps its insurance, leasing, and oil businesses. Its bank creditors, led by Citigroup and Credit Suisse First Boston, will have first claim on the proceeds. All told, businesses accounting for up to 40% of ABB's $22.6 billion in annual revenues could be sold.

ABB is just one of many European companies that are waking up to radical changes in the capital markets. In the boom that ended in 2000, companies borrowed freely to finance acquisitions or to make gigantic investments that often proved to be duds. ABB, for example, spent $2.8 billion on vendor financing and about $1.4 billion to buy its own shares, estimates Deutsche Bank analyst Mark Cusack. Now, lenders, especially Europe's growing corps of bondholders, are taking big losses as corporate debt ratings fall.

European debt holders, who have been slower to punish problem companies than their American counterparts, are now exacting their revenge. Lenders are forcing profligate borrowers and poorly managed companies such as NTL Group Ltd., the British cable leader, and KirchMedia, the once dominant German player, into restructuring--opening the way for new management, renegotiated deals, and sales of superfluous assets. They are also pressuring blue chips or former blue chips such as ABB, British giant Imperial Chemical Industries, and France Télécom to fix overlevered balance sheets. If they don't act, companies face sky-high interest costs from low-rated debt or, in the worst cases, insolvency--the fate of German construction company Philipp Holzmann. "Bondholders used to be treated like dirt. Now they're getting some respect," says Rick Deutsch, head of credit research at BNP Paribas in London.

Investors are turning up their noses at the growth stories that once attracted money like magnets. They are fixated on earnings and creditworthiness. "It is all very well to focus on growth and long-term expectations," says Neil McLeish, Head of European Credit Strategy at Morgan Stanley Dean Witter & Co. in London. "But if you can't borrow today, 2003 is irrelevant."

The problem isn't a shortage of cash, say bond market insiders. Bayer, which is far from a corporate star, successfully floated $4.4 billion in bonds on Mar. 26. Spreads on BBB-rated bonds, the lowest investment-grade class, are at 1.3 percentage points above Euribor, the rate at which banks lend to each other--well below the 2 points or so of last summer.

But the market has become much more discriminating. The recent high-profile meltdowns of Enron Corp. and Global Crossing Ltd. have spooked creditors and rating agencies. Companies that in normal times would have cruised along without intense scrutiny suddenly find they have less margin for error. "Right now I bet there are half a dozen European companies that are blue-chip names but in the privacy of their offices are in a state of panic," says a leading London banker.

No European bondholders' advocate has emerged with the stature of PIMCO's Bill Gross in the U.S., who recently blasted General Electric Co. But European bond buyers have grown tougher and more savvy. In the last couple of years they have demanded that major issuers such as France Télécom and British Telecom include stepup clauses in their contracts that give bondholders rate increases in the case of ratings downgrades. "I do think bond investors are gaining influence, especially in sectors such as telecoms and utilities, where companies are increasingly reliant on bond finance to fund capital expenditure," says Bernard Hunter, head of fixed-income research at Merrill Lynch Investment Managers in London.

Pressure from bondholders and the rating agencies has also forced some big companies to take defensive measures. Worried about a ratings downgrade, Britain's ICI recently offered $1.1 billion in new stock to its shareholders. On Mar. 18, Deutsche Telecom cut its dividend 40%, shoring up bondholders at the expense of shareholders. And in a bondholder coup, investors forced British Prime Minister Tony Blair's government to, in effect, bail out bondholders and equity investors in Railtrack Group, the disastrously privatized rail operator. Transport Secretary Stephen Byers had forced the poorly managed company into bankruptcy in October, vowing that investors would get nothing. But on Mar. 25 he announced a $10 billion rescue package that included a $420 million government grant. The government backtracked after City bankers made it clear that Blair's plans to raise billions more for public projects would get a rude reception if Railtrack investors were not at least partly compensated.

Still, bond investors say that across Europe, corporate management continues to ignore creditors' interests. France Télécom is a good example. Back in 1999, the company's debt was trading at just 30 basis points over government securities. Now, thanks to a series of ratings downgrades, the spread is 250 and Moody's is warning of a new downgrade. A year ago FT pledged to slash its $53 billion debt by as much as 30% by 2003, but it has made no progress.

When a small group of investors is involved, debt holders have a better chance of making their voices heard. For instance, the combined clout of News Corp.'s Rupert Murdoch and Italian Prime Minister and media baron Silvio Berlusconi looks set to force German tycoon Leo Kirch to give up control of KirchMedia, his main holding company. Kirch is on the brink of insolvency, with $9.6 billion in debt.

In Britain, the heavy debts of the two big cable operators, NTL and Telewest Communications, could open the way for the final round of consolidation in the potentially lucrative British television and broadband market. With NTL's share price down more than 90%, bondholders in January forced the company's overly ambitious CEO, Barclay Knapp, to agree to a restructuring. Bondholders are pushing to swap the company's debt for nearly all its equity. The company warned on Mar. 27 that it might run out of cash before a salvage job is finished.

Creditors would rather rescue companies than have them go to the wall. Only when a company seems hopeless do they put it out of its misery. In mid-March, banks reluctantly came to the conclusion that 150-year-old Frankfurt-based Holzmann Group was such a company. Chancellor Gerhard Schröder organized a $2 billion Deutsche Bank-led rescue of Holzmann just over two years ago. But with the company losing $210 million last year, the banks balked at another rescue. Holzmann filed for insolvency on Mar. 21, and it faces liquidation.

Europe's debt buyers aren't feeling sentimental. "One of the purposes of recessions is to winnow out some of the weaker companies that are not going to contribute to the next phase of the economy," says Morgan Stanley's McLeish. Given the excesses of the boom, Holzmann may not be the last to go.

By Stanley Reed in London, with David Fairlamb in Frankfurt, and Carol Matlack in Paris

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