The Deep Risks of 'Asset-Light' Debt

With sub-substandard collateral levels, some debt structures of the private equity buyout boom could come back to haunt investors

In the spring of 2007, private equity giant TPG decided it was time to pay itself a dividend from its $1.4 billion acquisition of Iasis Healthcare. TPG had bought Iasis, a hospital chain that serves midsize markets, three years before from its founder, private equity firm JLL Partners.

In such a move, called a dividend recap, a company's controlling equity holders borrow money that is used to pay a special dividend on the stock. Iasis is a solid, privately held business: It generates more than $100 million in yearly net income on revenues of $1 billion from its 19 facilities in a half-dozen states in the South and West. But Iasis still couldn't handle the enormous debt TPG sought to heap on: $1.1 billion. The Franklin (Tenn.) company's operations would be able to support about $829 million in debt.

So TPG created a special Iasis holding company that borrowed the $300 million the operating company couldn't support. For private equity firms, the holding company was a dream come true: They could cash out from their investment by borrowing heavily to fund rich dividends they paid to themselves and still retain the underlying business. That form of financial maneuver became fairly common during the past year, as the private equity boom reached its peak, according to Brett Barragate, a partner in Cleveland with global law firm Jones Day.

A Fad in Finance

The holding company note was part of a broader phenomenon known as asset-light debt, in which collateral levels are far below the usual standard of 30% or more of a company's enterprise value. Collateral could be around 10% or even nothing at all. Such asset-light deals were a bit of a fad in finance. They began hitting the market in late 2005 and grew in popularity through the first half of 2007 before grinding to a halt. Now, given the deterioration in global debt markets and the dramatic tightening of lending standards in the past month, it's unlikely such a structure would pass muster with investors.

Moreover, demand for corporate debt has dropped as the market for pooled loans, known as collateralized debt obligations, has dried up. On July 25, banks postponed plans to syndicate $12 billion in loans tied to the buyout of DaimlerChrysler's (DCX) Chrysler Group and $10 billion in loans tied to the buyout of British pharmacy company Alliance Boots. And on July 27, British beverage giant Cadbury Schweppes (CSG) announced that it was extending the bidding deadline for its U.S. brands, such as 7-Up and Snapple, "to allow bidders to complete their proposals against a more stable debt financing market."

Despite the new caution concerning debt risk, the loans that were funded using such structures will be around for years to come. Some experts believe that some of them could pose a significant risk of default if the economy slows or veers into recession.

Sweetening the Pie for Investors

There's nothing inherently wrong with this holding company structure, or other forms of asset-light debt, as long as investors have all the facts about what they are buying. In the past, off-balance-sheet debt that has been concealed from investors has led to problems such as Enron. While deals such as Iasis are completely above board, holding company structures are nonetheless riskier than many other forms of credit. "So, even today, banks will take a piece of the total debt that is needed and put it at the operating company level and a certain amount of debt above the operating company as a holding company loan," Barragate says. "The holding company loan isn't subject to collateral. It's a highly leveraged situation."

So what would make an investor stomach such an arrangement? Compensation. Investors usually deem their return level adequate for the amount of risk such deals contain. The interest on the senior, secured $829 million Iasis loan was in the range of 7%, while the interest on the $300 million unsecured debt was closer to 10%, according to Barragate. The default rate for holding company debt is 2%, about the same rate as conventional corporate debt defaults.

Here's the usual process in such deals: The new corporate entity is created with the sole purpose of owning stock in the original, operating company. The holding company can issue debt, even though it doesn't generate any revenue or profits. It can typically pay off debt in one of two ways. The operating company can give the holding company a cash dividend, which can be used to pay back interest and principal on the holding company's debt. If the operating company elects not to make the cash payment, the holding company doesn't have to worry about going into default, though. It simply adds its regular interest payments to the amount of principal that's due. The idea is that the holding company's debt can be repaid all at once in a few years when private equity investors sell the operating company or take it public.

Pushing the Envelope

That was a reasonable bet, since private equity firms almost always look to exit their investments in four or five years, if not sooner. But what if the operating company can't be resold at a profit? What if it goes bankrupt? In that case, investors in the holding company debt lose, just like equity investors are wiped out in a typical bankruptcy.

So while worst-case scenario risks are fully disclosed up front, the wrinkle in many such holding entities is that investors may have allowed sellers to underprice collateral-light debt during the buyout boom, when capital flowed freely and corporate debt demand far outstripped supply. That led investors to push the envelope when it came to risk, says Jeff Gary, a high-yield portfolio manager at asset manager BlackRock (BLK). Gary is part of a team that manages several funds, including a $1.8 billion high-yield bond fund and a $1.5 billion high-yield income fund. "The holding company structure typically paid 9% to 11% yield. In our view, such credit is comparable to senior equity and should have had a higher return to compensate for the risk," Gary says. "Therefore, we passed on the vast majority of the holding company deals that came to market."

The amount of holding company debt and other forms of asset-light exposure is difficult to quantify, according to Steven Miller, head of Standard & Poor's Leveraged Commentary and Data. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP)). Examples of various kinds of asset-light debt include Clayton, Dubilier & Rice's $5.5 billion buyout of lawn care company ServiceMaster, Kohlberg Kravis Roberts' $7.1 billion acquisition of U.S. Foodservice, and the $6 billion buyout of craft supplier Michael's Stores by the Blackstone Group (BX) and Bain Capital (see, 7/5/06, "Private Equity Takes a Shine to Retail").

Others include Apollo Management's $1.8 billion Rexnord deal, according to Barragate. Carl Icahn's attempt to take over auto parts maker Lear (LEA) had a collateral level of just 10%, according to Shelly Lombard, a senior credit analyst with Gimme Credit. Investors ultimately rejected the Lear deal, deciding the price was too low.

Offsetting Potential Risks

Collateral levels are crucial when it comes to evaluating a loan. Collateral refers to the percentage of a company's value that is secured by a hard asset that can be sold in the event something goes wrong. Creditors like to see collateral levels much higher than 10%, typically around 30%, if not 40% to 60%, This is comparable to a mortgage on a house. The value of the house is collateral for the loan, because the bank can seize possession of the house and sell it if the borrower defaults.

A high degree of collateral can offset many potential risks for investors. The bank loans used to support Blackstone's buyout of chemical company Celanese (CE) were well received by the market, despite the lack of covenants in the lending agreement, says Payson Swaffield, an asset manager at mutual fund company Eton Vance. That's because the company's $3 billion loan was a manageable 30% or so of its $9.5 billion enterprise value. "The Celanese deal was covenant light, but they could get away with it. The bank debt was not impaired," says Swaffield.

Despite the current turmoil roiling the credit markets, asset-light structures could still be profitable investments—if companies such as Iasis remain in the black. But if the economy runs into trouble, some companies that issued such debt will face intense pressures. Those investors would be last in line to get paid in the event of a bankruptcy. If that happens, investors' one viable option "is to sell the entire company and hope that the enterprise value is sufficient to pay off their claims," Barragate says. "They have no other recourse."

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