Sometimes Merger Math Just Doesn't Add Up

It can make risk seem to disappear

For six years private equity firm Thomas H. Lee Partners tapped the credit markets to buy one consumer-products brand after another and roll them all up into United Industries Corp. But even though United's total debt jumped from $375 million to $860 million by 2005, its leverage—one measure of a deal's riskiness—didn't move much.

How could that be? Part of it was the magic of merger math, a naturally occurring phenomenon that has helped drive $1 trillion in buyouts since the boom began in 2004. It's a pretty simple illusion that happens when a company with a lot of leverage buys one with less. That combined debt load is then spread across all the assets of the new corporate entity. So some key measures of leverage often remain the same or even drop, making it appear from one angle as though there were no additional risk. That can be true even if the acquirer pays the seller a premium, which is usually the case.

When THL first bought United in 1999 for $652 million, it borrowed much of the funds, adding $370 million in debt to the company. That left United's debt load, then rated at a junk B level, at around 6.2 times operating profits, a ratio typically used by lenders and rating agencies to size up a company's borrowing capacity. The company's operating profits were roughly 1.7 times its interest cost on that debt, known commonly as interest coverage.

Three years later, United borrowed as much as half the purchase price for three businesses in fertilizer, potting soil, and insect repellent. Yet by doing so it added enough extra operating profits to reduce its leverage to 5.3 times; interest coverage improved to 2.1, according to estimates at the time by Moody's Investors Service (MCO ).

Other deals followed much the same formula. United's total debt jumped 60% when it bought Nu-Gro Corp., a garden products company, in March, 2004, while its leverage ratio rose just 30%. At the same time, interest coverage got a nice boost since United borrowed using more lower-cost floating-rate loans instead of higher-cost fixed-rate bonds; United's average cost on its debt plunged to 5.71% from 8% a year earlier. When it acquired United Pet three months later, debt increased by 50%, while leverage rose only modestly.

This financial hocus-pocus isn't a problem provided business improves and earnings continue to grow. But the magic can quickly disappear when things go wrong—as happened after United merged with Rayovac to form Spectrum Brands in 2005. Even though its debt stood around 5.5 times profits—no more than it was after the original United deals a few years earlier—that load became a crushing burden.

By David Henry

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