Private Equity's Big Debt Burden
Private equity's torrid buyout binge has lenders rewriting the rules of debt, with firms borrowing once unimaginable sums to pay for their record deals.
As recently as 2004, the average buyout was funded with $4.50 of debt for every dollar of a target's cash flow. No longer. Now average debt levels are a record 5.9 times cash flow, and debt multiples of eight or nine times are common. The changes have been driven by a number of factors, including low interest rates, cash-flush lenders, and the belief that healthy corporate earnings and cutting-edge management mitigate risk.
Soaring Debt Ratios
In April, Chicago real estate mogul Sam Zell shocked many observers with his $8.2 billion deal for media giant Tribune (TRB) (see BusinessWeek.com 4/2/07, "Zell's Big Plan for Tribune"). The astonishment wasn't from the price so much as from the structure of the deal, which involves a two-part plan to acquire outstanding shares and will leave the company with as much as $13 billion in debt—10 times its cash flow.
And just last week, TPG Group and GS Capital Partners, a unit of Goldman Sachs (GS), announced that they would take Arkansas-based telecom Alltel (AT) private in a $27.5 billion deal (see BusinessWeek.com, 5/21/07, "Private Equity Dials Up Alltel"). The company's debt ratio will rise to about eight times earnings before interest, taxes, depreciation, and amortization, or EBITDA, according to analysts.
Debating Default Prospects
An increasing number of investors, including private equity pioneer Wilbur Ross Jr., argue that a big wave of credit defaults is forming at the lower depths of the junk-bond market. "I think default rates will go up a lot," says Ross, who became a billionaire by investing in distressed industries such as steel and auto parts (see BusinessWeek.com 5/15/07, "Wilbur Ross: No Chapter 11 Here"). "We think they will at least double by the end of this year and at least double or triple by the end of next year."
Not everyone is so sure the default rate is about to spike. They contend that higher leverage ratios are acceptable because low interest rates and a healthy business environment mean that many stronger companies can afford to take on high debt without incurring unmanageable risk. "A path to higher risk and leverage is visible for the corporate sector amid the private equity buying binge. However, this remains a path to be trod," Citigroup (C) analyst Steven Wieting said in a May 18 report, "Leverage & Growth—Get Used to Them Both."
One hedge fund manager agrees. He says even weaker companies can live with high debt, at least for now. For the moment, they face few loan conditions that can trigger a default—and if they get into trouble, someone else lends them more money. "I see a tremendous amount of liquidity in the financial system and no signs of it drying up," says Ralph Rosenberg of R6 Capital in New York. "Even if companies hit 'speed bumps,' it will be a while before they run into problems with their lenders. I think the only thing that changes this is if there is complete repricing of risk across all asset classes—debt, equity, real estate, etc." Such a scenario could come in the form of a terrorist attack or some other cataclysmic event, Rosenberg says.
Weak Companies More Vulnerable
There is evidence, however, that default rates already have started inching up from historically low levels. The default rate on U.S. corporate debt is 1.44%, up from 1.26% at the end of 2006, according to Diane Vazza, head of global fixed-income research at Standard & Poor's (S&P, like BusinessWeek, is a unit of The McGraw-Hill Cos. (MHP).) Vazza, who also worked in finance at junk bond pioneer Drexel Burnham Lambert in the 1980s, believes that the default rate will hit 2.3% by the end of 2007, and rise to 2.5% by the end of first quarter of 2008.
Vazza bases her forecast on several trends in the market. Leverage ratios are higher than they have been in 10 years. The average debt-to-EBITDA ratio for U.S. buyouts is 5.9%, up from 3.94% in 1991, the first year for which S&P has data.
High leverage ratios could hurt companies with weak businesses, especially if rates rise or the economy weakens. And there are plenty of weak businesses. The percentage of companies at the lower-end of the junk bond market is rising. The percentage of junk bonds that carry a B-minus rating or lower is 49%. That's up from 30% in 2003, 46% in 2004, 44% in 2005, and 43% in 2006, according to S&P data. "We can see the seeds of the next wave of defaults and distress being sown," says Vazza.
That has bankruptcy and restructuring lawyers getting ready for a boom in business. "I agree that default rates are going to rise. They have been kept low, in part, by the use of 'covenant-light' debt," says Jay Goffman, a senior partner at Skadden, Arps, Slate, Meagher & Flom. "That means there are few covenants to default on, short of not making payments. But that holiday often ends after two or three years."
Decline in Lending Standards
Ross argues that the current wave of buyouts will end badly because some private equity firms have stripped too much value from some companies, leaving them ill-equipped to operate their businesses. "Only about 11% of [high-yield offering] proceeds have been for capital expenditures to enlarge the business, with the rest going for sponsor dividends, stock buybacks, refinancing of existing debt or LBOs—not the most exciting uses of proceeds," Ross says.
He's also alarmed by the decline in corporate lending standards, which he compares to the subprime mortgage meltdown. "I believe that credit markets have been recklessly permissive to the point where instead of traditional risk-adjusted rates of return the market is dealing with what I would call risk-ignored rates of return," Ross said. "The rating agencies recently have begun to revise upward their forecasts for late '07 and '08 but are still a bit below mine."
Few would argue that defaults will remain at the current low level. The question now is how high and how quickly they'll rise, and how broad the problem will be.