Done Deals in Distress

Debt issued for recent buyouts is fast losing value. That could hurt private equity fundsand their investors

Contrarian investor Sam Zell rarely bets on an easy turnaround. That's good, because his $12.7 billion buyout of Tribune Co. (TRB) could be messier than even he expected. With the ink barely dry on the deal, the loans and bonds used to finance the transaction are, on average, trading for about 75 cents on the dollar. By that measure, investors have shaved almost $4 billion off the value of the media conglomerate since Dec. 20.

The credit crunch that has forced private equity firms to scrap or shelve about $114 billion in pending buyouts since the summer has now spread to completed deals≠≠. Like Zell, almost every buyout shop has a company with bonds or loans trading at dramatically lower prices. Overall, 31% of the bonds issued for buyouts since 2002 sell at a discount, estimates a study by Martin Fridson at New York debt-research firm FridsonVision. And some 40% of the deals at Bain Capital, Apollo Management, and Thomas H. Lee Partners have distressed debt. "[The companies] look like houses that are suddenly worth less than the homeowners paid for them," says one investor in private equity funds. Says a THL Partners spokesman: "This study grossly misrepresents the performance of THL's portfolio companies." Zell and Bain declined to comment.

"WALKING ZOMBIES"

The implications are significant. Until recently, private equity players could bank on quick profits. Often buyout barons paid themselves a big dividend by issuing new debt just months after taking a company private. Today the debt markets are signaling that firms may have significantly overpaid for deals. That means they will have a hard time refinancing or selling those companies for a profit anytime soon, if ever. As a result, some of the megabillion-dollar buyout funds they started in the past several years—the ones stuck holding these companies—could turn out to be duds for the pension funds, endowments, and high-net-worth individuals that invested in them. "Many buyout deals look like walking zombies," says Michael J. McGonigle, a high-yield bond fund manager at T. Rowe Price (TROW).

The distressed debt will dampen future dealmaking, which over the past few years has been a driver of stock prices. There were 10% fewer deals announced in the second half of 2007 than in the first half, according to Thomson Financial. And on average, those transactions were 63% smaller by dollar value.

To some bond veterans it looks a lot like the late 1980s, in the wake of the savings and loan crisis. Back then the junk-bond market collapsed, cutting off the supply of capital for companies going private. Bond prices tumbled, harming investments like Kohlberg Kravis Roberts' $32 billion purchase of RJR Nabisco in 1989. It took KKR around 13 years to completely exit its RJR investment, an outcome KKR has called "disappointing." "The S&L crisis elevated risk aversion, which turned the prior LBO craze upside down," says T. Rowe's McGonigle. "The financials meltdown has prompted a similar impact today."

When the credit crunch hit last summer, investors' appetites for risky debt diminished. But the nature of the buyout debt complicated matters. Traditionally, the contracts governing debt include what are known as covenants, essentially safeguards for the creditors in case a company goes bankrupt or defaults. But most of the debt issued for buyouts in recent years has looser terms, giving bondholders fewer rights. Without those protections, investors are demanding a different safety net in the form of cheaper prices. So "a bond that would probably trade at 80 cents on the dollar with a covenant is now going to trade at 60 cents to 40 cents on the dollar, since it has no covenant," says Marc Lasry, CEO of the $20 billion Avenue Capital Group, which specializes in distressed debt.

A huge overhang is depressing prices further. Investment banks are stuck with an estimated $200 billion in bonds and loans from buyouts on their books, which has squeezed their profits alongside subprime.

And the biggest buyers of that debt last year, managers of collateralized debt obligations, are struggling to repair their portfolios filled with toxic mortgages and other investments gone sour.

Meanwhile, other buyers are being picky. Distressed debt funds—which raised a record $24 billion last year, up from $7 billion in 2006—are demanding higher returns or bulletproof guarantees like the "most-favored-nation clause," in which banks agree to buy back the debt if its value depreciates shortly after the sale. Some are even asking banks to help finance their debt purchases, debt traders say. "They know that if one of these buyouts goes bad, all the bonds in the market could drop," says one buyout veteran.

UNFAIR PUNISHMENT?

The deals getting whacked the hardest are in especially troubled industries such as real estate, retail, and newspapers. Take Apollo's $8.75 billion buyout of Realogy, a collection of real estate brokers such as Century 21, Coldwell Banker, and Corcoran Group. Nine months after the deal closed, debt investors have marked down the value of the company to $5 billion. If it had to sell Realogy today, Apollo would lose the entire $2 billion it ponied up for the purchase. Realogy officials declined to comment.

Some firms argue that the punishments being doled out in the debt markets are unfair. The beaten-down valuations, they say, ignore companies' underlying financials. "One of the keys in analyzing what is and what is not distressed is how an acquisition is performing—and especially how it was capitalized and structured," says Steven Anreder, a spokesman for Apollo, which has two other companies with discounted debt. Kathleen Waugh, a spokeswoman for Toys 'R' Us with bonds at 68 cents on the dollar, echoes: "We are pleased with our performance. We cannot control market conditions."

Maybe so. But it may take a while for the companies to justify the initial sky-high valuations. And if the economy slips into a recession, defaults are inevitable. All of which means firms may be forced to hold on to these companies far longer than many imagined. "The argument that the recent funds will result in great returns is almost fanciful at this point," says one investor in buyout funds.

It's not unlike the situation venture capitalists faced after the dot-com bubble burst. Such players raised record amounts from investors lured by the dazzling returns of previous, smaller funds. But later funds flamed out when the companies failed to live up to their high price tags. Burned investors are only now beginning to regain interest in VC funds.

The road to recovery could be equally long in the buyout world. Says Alan Kosan, head of private equity research at investment adviser Rogerscasey in Darien, Conn.: "Five years from now, these firms will still be owning the companies and hoping they grow out of the high valuations."

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