Have Investors Learned Their LBO Lessons?
Have Investors Learned Their LBO Lessons?
The following is an excerpt from a Standard & Poor's Ratings Services report released on Nov. 26
Leveraged buyouts are the amazing process of using other people's money to take control of a company. You can easily parlay a modest investment into a large enterprise if you know what you're doing and the timing is right. For example, in the 1980s, financial sponsors were able to finance LBOs by contributing a modest investment of 10% to 15% and borrowing the rest.
Of course, sponsors need willing investors to pull this off, but that hasn't been much of a problem. Over the past couple of decades, we have found investors are only too willing to back LBOs. After all, it sure beats putting your money in Treasuries as far as returns are concerned. And while the record of LBOs is littered with some major failures, Standard & Poor's Ratings Services also has seen successes. After falling into speculative-grade territory, some have even had post-LBO ratings return to the investment-grade level.
The basic premise behind LBOs is that loading a huge debt burden on a company creates an atmosphere of financial discipline for it and the management team, which facilitates cost cutting, the divestiture of noncore businesses, or both. If the sponsors are lucky, they can pay off some debt with these efforts, improve operations, and walk away with a bundle when the company later goes public.
In more recent periods, sponsors have seemed to prefer pulling out cash with special dividends to earn their return more quickly and reduce their exposure. While the first model sometimes has translated into credit improvement, the second approach is likely to lead to credit deterioration and damage to the company's longer-term prospects.
Missing many of history's lessons
Since we've been through both peaks and troughs in LBO activity over the past 20 or so years—and especially in light of the current turn away from the easy credit conditions that helped set records for LBO dollar volume in the past couple of years—now is a good time to ask: What can history teach the market about LBOs? From our vantage point at Standard & Poor's, many lessons are clearly marked on history's blackboard, with a number of examples showing the good, the bad, and the ugly of LBOs (BusinessWeek.com, 12/3/07).
However, it's not at all clear the market has learned anything over the past 20 years. Sure, the private equity firms that often sponsor LBOs have figured out how to take their money and run, thanks to special dividends and the like. But on most other counts, not much has changed. If anything, today's LBOs push the debt envelope even further. We would be hard pressed to identify LBOs in the '80s as leveraged as the ones we've seen over the past couple of years.
Further proof the market has been overreaching resides in the ratings we've assigned to LBOs of the last few years, vs. those of the '80s. While we certainly did assign B ratings to LBO transactions back then (such as to Macy's and Federated), these were exceptions. In the '80s and until recently, the majority of LBOs were structured to reach a B+ rating. Today, B, and even B-, ratings are far more common, and investors seem to regard such ratings as little more than the price of admission. If the risk of overburdening companies with debt was a lesson that should have been learned, it appears a lot of people cut class that day.
The Mistake Many Companies Make
Another LBO history lesson is that bad timing can be deadly. You can have a good business with a strong franchise, but if your timing isn't good, it may not matter. This lesson should be especially clear to companies in more cyclical businesses. Macy's and Federated were strong retailers, but both found that managing a highly leveraged company going into a recession isn't the easiest thing to do. This is often a characteristic weakness of LBOs: no cushion.
Highly leveraged companies, especially in cyclical businesses, need realistic alternatives should things take a turn for the worse.
Problem is, companies often think they'll always have access to more debt or that they will grow into their debt load. Indeed, their models seem to show that's how it will work. Companies must always remember that the economy can worsen, and capital markets can quickly become less receptive. Bottom line: It takes more than wishful thinking to get an LBO through those difficult periods.
History also teaches that fixing a problem company by taking it private through an LBO is not a sure thing. Going private may rid a public company of those pesky shareholders who never seem to be satisfied, but dealing with a huge debt burden when a company isn't firing on all cylinders may be a bigger problem. History has shown that adding piles of debt to a troubled company is a good way to go bankrupt.
A Cushion Makes the Difference
The message isn't all doom and gloom, because over the years many LBOs have turned out successfully. Some have made it back to investment grade, while they nurtured and strengthened their businesses. Companies such as Duracell, Harley-Davidson (HOG), and even RJR had strong franchises and products people wanted, which translated into strong cash flows and, ultimately, lower levels of debt.
Some companies understood the challenges of managing a much larger debt burden and structured their finances accordingly. A key to success for most LBOs is understanding the value of committed additional liquidity and knowing the debt terms they can live with.
Thinking ahead isn't a bad thing for an LBO, and having that extra financial cushion has been the difference between bonanza or bankruptcy on more than one occasion. And, every once in a while, a company is fortunate enough to use the LBO process to exploit favorable growth prospects. Instead of worrying about quarterly performance, such companies can pursue a plan that improves the business and returns them to investment grade. Of course, it helps to have a business that can be nurtured this way.
Some Things Never Change
Some of the recent crop of LBOs undoubtedly will emerge as success stories. However, when you consider how much more debt many current LBOs are carrying compared with their predecessors, a higher failure rate is more likely.
From where we stand, the attitude toward very high leverage sometimes seems to be indifference, which translates into weak planning or financial imprudence. Over the years, some reasonably strong companies have failed with less leverage than companies are taking on today. Although some will argue times have changed (and we agree in many respects), companies still must service the debt they take on. And while the market now appears more concerned with risk than it was just a few months ago and is demanding different terms, for some LBOs it's probably too late for a more realistic approach.
Check out the BusinessWeek.com slide show for S&P's roundup of the good, the bad, and the ugly of LBOs.