The Rising Tower of Debt

As leveraged buyouts soar, the buyers are borrowing more and more money, raising the risk of default. To some, it's a bubble in the making

If the deal market maintains its current hot pace, the tidal wave of leveraged buyouts (LBOs) is on track to hit a record $98.8 billion in 2006. That would eclipse the record of $94.5 billion established in 1988, according to Meredith Coffey, a senior vice-president and director of analysis at Reuters Loan Pricing Corp. (RTRSY).

As the volume of LBOs moves into '80s-era territory (see, 5/2/06, "The LBO Meets Main Street"), another characteristic of that period is making a comeback. Lenders are allowing private buyout firms that fund transactions with debt, or leverage, to borrow more and more money.

It's difficult to know just how much debt LBOs are taking on, because privately held companies aren't required to file financial reports with the Securities & Exchange Commission, the way companies that issue shares to the public are. But Loan Pricing Corp. keeps a handle on the market by monitoring loan covenants that cap the debt ratios lenders allow borrowers to take on. While it can't track the actual debt level in a given LBO, it knows what the caps and collars are. And it's clear that borrowers are on a longer leash. The debt ratio of the average LBO, measured as a debt multiple of cash flow, is 6.62 for the year to date. That's high by recent historic standards. Debt levels have increased every year since 2001, when they were 4.49. They are up from 6.4 last year, although they exceeded 10 in the late '80s.


  The crucial issue is whether the assets being acquired can produce enough earnings growth to pay off the debt. Last year, Silver Lake Partners led a group of private-equity firms that took tech company SunGard Data Systems private in an $11.3 billion LBO. The debt load in that deal is nearly eight times cash flow, and payments on the debt already are wiping out earnings, according to the financial statements that SunGard files because its debt is publicly traded. Interest expense for the first six months of the year was $318 million, according to company documents. Operating income was $212 million. The result was that the company had a net loss of $76 million, after considering other factors.

The new owners must boost SunGard earnings. That won't be easy, though. Earnings have been declining while interest expenses have been rising. Interest expense was $265 million for the year ended Dec. 31, 2005, compared with $29 million for the year ended Dec. 31, 2004, the company said in a filing. Earnings were $493 million in 2005 and $704 million in 2004. SunGard declined to comment.

Some experts believe the number of defaults in the credit market is bound to rise. "There's no doubt there's some sort of bubble going on in leverage. Just look at the statistics and the dollars being raised. Most bubbles end when someone takes a pin and pops them," says David Ying, co-head of the restructuring department at investment bank Evercore. He doesn't expect the bubble to pop for a number of years, though, because the economy and market are still fairly strong.


  But at some point, companies under pressure will want to refinance their debt. And lenders will raise the risk premium, forcing them to borrow smaller amounts of money at higher rates. That's when the weaker companies will default.

Some increase in the risk of default is almost guaranteed, because default rates are so low right now (see, 7/18/05, "Too Much Cash, Too Little Innovation"). They are hovering at just over 1%, while the historic average is more than 4%. That's because interest rates are still at historically low levels, the economy is in solid shape, and corporate earnings and cash levels are very strong. Should those conditions change, the risk of loan defaults in all sorts of markets could increase, as well.

The economic risk may be exacerbated by factors within the LBO market. Lenders are competing for business by offering favorable terms in a borrower's market. Some of the loans that are being used to fund buyouts allow borrowers to make interest-only payments for five to seven years. That gives the buyout firm a chance to sell the company or take it public and avoid the added financial pressure of having to repay principal as well as interest.

"There is a lot of money out there chasing yield, and there are a lot of nontraditional lenders who aren't bound by traditional means. They can look at loans on a case-by-case basis," says Frederick Lane, chairman and CEO of investment bank Lane Berry.


  Analysts say the rising debt levels must be viewed along with other factors such as lower interest rates, which make it easier to carry higher debt loads. "You can't look at those numbers in the abstract. You have to consider them in the context of financial conditions in the market, asset quality, the sophistication of buyers, and the ability of groups of buyers to spread risk amongst themselves," says Donna Hitscherich, a professor on the finance and economics faculty of Columbia University.

Hitscherich, a former M&A attorney and investment banker, says the assets sold in the '80s were typically slower-growing industrial companies. Buyouts now include other types of businesses from retail to tech, which may be able to support more debt (see, 12/20/05, "Of Donuts, Debt, and Deals").

But credit rating agencies are taking a very close look at the debt ratios that are emerging from today's LBOs. On April 7, Moody's picked up coverage of Sensata, the former sensors and controls business of Texas Instruments (TXN). Bain Capital agreed to purchase the unit from TI for $3 billion. Moody's said the company's "high debt leverage" as a standalone company would reduce its financial and operating flexibility. Sensata didn't respond to a request for comment.


  Many of today's highly leveraged LBOs carry junk-bond ratings. While junk bonds can often make good investments, they do carry a higher risk of default. On July 13, Standard & Poor's lowered the corporate credit rating of Oriental Trading Co. to B from B+, pushing it even further into junk territory. S&P said it was concerned about Carlyle Group's use of leverage in its June 11 acquisition of the party supply company. Terms of the deal weren't announced, but Coffey, of Loan Pricing Corp., said the debt was about 7.2 times cash flow.

S&P said it was concerned about the company's "highly leveraged capital structure." S&P said Oriental Trading faced a variety of business challenges, from a fragmented market to seasonal buying periods that make revenue uneven. Oriental Trading didn't respond to a request for comment.

Reflecting similar concerns, S&P downgraded Rexnord on June 14. The industrial company in Milwaukee is being acquired by Apollo Management for $1.8 billion. Coffey says the company will emerge from the deal with a debt-to-cash-flow multiple of 6.75. On completion of the proposed transaction, S&P said it will lower the corporate credit rating to B from B+. Rexnord didn't respond to a request for comment.

History teaches an unnerving lesson when it comes to the debt markets. The volume of LBOs crested in 1988, at $94.5 billion, when double-digit leverage ratios were common. By 1992, the volume of LBOs had dropped to $2.6 billion. The few companies that could fund buyouts had to maintain much more modest leverage ratios. When it comes to LBOs, what goes up often comes down.

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