Credit Quality Slips in the M&A Boom

A boom time for mergers and buyouts has led to declining credit ratings amid a torrent of debt

The current mergers-and-acquisitions boom has, by almost any measure, been extraordinary. The value of the M&A market rose about 30%, to a record $4 trillion, in 2006, and some analysts expect another record year in 2007 (see, 12/19/06, "Deals of the Year, in a Year of Deals").

That's great news for many market participants, especially the private equity firms leading the expansion (see, 1/9/07, "Finance Salaries: Up, Up, Up"). Yet financial experts are quick to point out that every boom is followed by a bust. While that might not always hold true, it's been true enough to give anyone who is benefiting from the latest boom in M&A reason for pause. And there's plenty of evidence to support the boom-bust theory. The expansions of the buyout markets and savings and loan industry in the 1980s and the telecom and Internet markets in the 1990s both ended badly.

Signs of a Meltdown

While the current boom may continue throughout this year and into 2008, some experts already are sifting through the data for early indicators of future trouble. On Mar. 7, analysts at credit-rating agency Standard & Poor's voiced some of their fears on a conference call with clients. (S&P, like BusinessWeek, is owned by the McGraw-Hill Cos. (MHP).) The analysts warned that the rise in M&A is hurting credit quality in many sectors of the economy.

The risk is that highly indebted firms lose the flexibility to make strategically important acquisitions or investments. Some could have trouble meeting debt payments if the economy runs into trouble. But perhaps the greatest risk is that many of these deals will require balloon payments in several years. The assumption is that interest rates will remain low and that the companies will be able to refinance their debt, or that they will be resold or taken public. But if those assumptions turn out to be wrong, companies could be stuck having to refinance at higher rates that weaken their cash flow or even threaten their solvency.

"There will be a downside," the agency cautioned in its report, warning that its rating service "expects many of these transactions to have a deleterious effect on credit quality." Last year, 6 of the 10 largest deals resulted in ratings downgrades or in companies being placed on credit watch with negative implications. That was true for AT&T's (T) $89.4 billion buyout of BellSouth. AT&T was placed on ratings watch, as was hospital company HCA, after its $32 billion buyout by the Blackstone Group.

Soaring Debt Ratios

While big companies such as AT&T are unlikely to be harmed by a slight downgrade in their investment-grade debt, the majority of buyout targets are smaller companies without AT&T's vast financial resources. And private equity is soaring, accounting for 20% of all deal volume in 2006, up from 13% in 2005, according to Thomson Financial (TOC). The percentage of deals that employed leveraged financing, or debt, rose to 57%, the highest level in several years. While that's below the record percentage of leveraged deals (71% in 1998) it's a record in absolute terms. "In 2006, buyers borrowed $273.5 billion for takeovers and mergers, more than double the previous year's total and a third more than the $182.5 billion seen in 1998," S&P said.

The competition for buyouts is on the rise (see, 2/13/07, "Private Equity Slugfest"). That's helping push up prices for assets. Private equity firms, which already use debt to boost their returns, are using increasingly higher leverage to finance costlier transactions. Debt ratios in leveraged buyouts such as the $16 billion LBO of Freescale, the Austin (Tex.) semiconductor maker, are running six or more times earnings before income taxes, depreciation, and amortization (EBITDA). A few years ago, debt ratios of three or four times EBITDA were typical.

Some private equity investors agree that debt levels are running high and that problems could arise as a result of weaker credit. "I think S&P is right," says Michael Chu, co-founder of private equity firm Catterton Partners. He says Catterton, which is focused on the consumer market, typically keeps debt levels to only two times EBITDA.

Risk-Prone Sectors

Not everyone agrees that debt and credit problems pose major risks. "It's true that risk will rise as credit quality slips, but most defaults reflect a fundamental problem with the deal itself. A bad deal is going to blow up, often regardless of the debt level," says Phillip Phan, a professor of management at the Lally School of Management at Rensselaer Polytechnic Institute in Troy, N.Y.

Certain industries come with more risk than others. Players in real estate investment trusts could see rising levels of risk as REITs become buyers of other funds, and not just targets in deals, S&P says. Telecom and tech deals could become riskier as overcapacity pressures margins, depressing the cash flow necessary to pay down debt.

To date, the level of distressed debt and defaults remains low. But given the recent history of boom-bust cycles in telecom, savings and loan associations, and other industries, cautious skeptics are seeking the first whiffs of trouble at the height of the M&A boom market.