End of the Private Equity Party?

Investors have grown leery of "toggle" notes and other high-risk debt. That may slow private equity's buyout boom

When it comes to borrowing money, it has been pretty close to anything goes for private equity firms in recent years. Not only have investors been willing to gobble up billions in high-risk debt used to finance private equity deals, but banks have also loosened their lending requirements, helping to drive the record volume of leveraged buyouts (see BusinessWeek.com, 6/4/07, "The Private Equity Effect"). The interest rates paid on bank loans dropped to all-time lows. Requirements for collateral were loosened. And then there was the new breed of "toggle" notes. If a company that borrowed billions couldn't generate enough cash to make its interest payments, no problem. Toggle notes let them borrow even more money to make the payments and stay afloat.

Now, it looks as if those free-wheeling times are over. A deal that is expected to hit the market on July 10 reflects the new reality. Clayton, Dubilier & Rice had originally planned to finance its $5.5 billion buyout of lawn-care product maker ServiceMaster (SVM) in part with a $1.15 billion offering that included toggle notes. But the deal was pulled prior to the scheduled July 3 date, in the face of weak investor demand. Now, ServiceMaster hopes to raise the money through more traditional, syndicated bank loans. Demand for the bank debt will shed some light on just how conservative the lending environment has grown during the past few weeks.

This summer will mean other tests for private equity. Kohlberg Kravis Roberts' $29 billion buyout of First Data (FDC), which includes $14 billion in term notes and $7.5 billion in high-yield bonds, is expected to come to market in late July or early August. A plan to issue $2.5 billion in toggle notes already has been dropped. Market analysts are waiting to see if other changes in the structure are necessary. In another high-profile deal, finance experts are watching how pension debt related to Cerberus' buyout of the Chrysler Group unit of DaimlerChrysler (DCX) is received by the market.

Peak Market for Going Private

Toggle notes may serve as a sign of the excesses of recent years. The name comes from the fact that borrowers could toggle, or choose between two different repayment methods, on their loans. They could either make interest payments in cash or they could make them with "in-kind" debt, effectively borrowing more money to pay interest on the money they had already borrowed. A number of such debt offerings have been pulled in recent months, including one that had been planned to help fund KKR's $7.1 billion acquisition of U.S. Foodservice. Now, KKR will use more conventional financing. "Investors finally had enough and began to push back," says Payson Swaffield, co-head of bank loan funds at money manager Eton Vance.

As lending standards tighten, some analysts believe that the boom in leveraged buyouts may have peaked. That doesn't mean that the market will crash or even decline very much. But the conditions that have propelled buyouts to ever-higher levels are shifting, raising doubts about whether the record pace can be sustained. "History may show this is the peak period for prices paid for companies going private," says Swaffield. Steve Miller, head of Standard & Poor's Leveraged Commentary and Data, agrees: "I think we have reached a peak in the [leveraged buyout] market." S&P, like BusinessWeek, is owned by The McGraw-Hill Companies (MHP).

Reaching a peak now may save the LBO market from more woe later on. In their eagerness to do deals, private equity firms have been piling on the debt, raising the risks of trouble in the future. Debt ratios have been running as high as 10 times earnings before interest, taxes, depreciation, and amortization (EBITDA), whereas five years ago the typical debt ratio was between four and five times EBITDA. For example, Sam Zell's $8.2 billion buyout of Tribune Co. (TRB) will leave the media company with $13 billion in debt, or 10 times EBITDA. TPG's $27 billion buyout of Alltel (AT) will leave the wireless telecom company with a debt ratio of eight times EBITDA.

Clamping Down on Minimal Collateral

As a general rule, "that's too much leverage, especially for companies with narrow margins," says Kevin Booth, managing director of asset manager BlackRock (BLK). Miller, of S&P, predicts that leverage ratios will now drop down into the seven-times-EBITDA range. That would mean turning back the clock a year or so. Blackstone's (BX) $17.6 billion acquisition of Freescale in 2006 left the semiconductor company with a debt ratio of about six times EBITDA.

The tightening of standards for borrowers has been limited to a few areas so far. Investors are balking at toggle notes and high debt ratios, as well as lending with nominal collateral. Private equity firms have recently tried structuring deals so that there's little collateral for loans. For example, a company could borrow money through an off-balance-sheet entity so that its debt ratios looked more reasonable. But lenders won't be able to claim the company's assets as collateral if anything went wrong. "Covenant-light notes get all the attention, but what we are really concerned about are asset-light notes that compromise collateral," says Swaffield. He points to KKR's $7.3 billion buyout of Dollar General (DG) and Clayton, Dubilier & Rice's ServiceMaster acquisition as examples of deals that are light on collateral (see BusinessWeek.com, 3/12/07, "KKR's Deal for Dollar General").

Still, finance industry experts say that the tightening of credit standards may be just beginning. With the troubles in the subprime mortgage market and elsewhere, investors may be starting to lose a bit of their appetite for risk. Caution now may save them from more serious troubles later. "We saw some leverage and some structures we didn't like, and the market pushed back," says Swaffield. "I think it's a positive development for the market."

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