LBOs: High Leverage, Low Ratings, Bad Timing
Looking back, it's hard to believe only a couple of years have passed since some of the largest leveraged buyouts (LBOs) in history were launched. These modern giants dwarfed almost all the large transactions from the 1980s, with several exceeding $20 billion or more. Yet the current crop didn't seem to learn at least one of the lessons from its predecessors—the lesson of bad timing. Bad timing can lead to failure for LBOs, regardless of business strength.
In the late 1980s and early 1990s, this was true for many companies, including Federated Department Stores, R.H. Macy, Revco Drug Stores, and Southland Corp.—and it is true today for Tribune Co., Harrah's Entertainment, Station Casinos, and Realogy, to name a few. In fact, because many LBOs from the current period were carrying more debt, they ran into trouble more quickly than their counterparts from the 1980s.
A mountain of debt can be quite unforgiving when one's business is under stress or the economy is struggling through a difficult recession. Of course, in a period of financial exuberance, it may be difficult for some to foresee anything going wrong. For example, Tribune, a company facing difficulties before its buyout, filed for bankruptcy within 12 months of its LBO. Even Revco, one of the quickest LBO failures among the 1980s crop, was able to survive for a longer period.
Importance of a Cushion
History has shown that the best businesses for LBOs are those with a stable and predictable cash-flow stream, not ones with significant operating problems. While Tribune may be one of the more obvious misjudgments among recent LBOs, there were other, more subtle variations on the power of positive thinking (or perhaps more appropriately, of "wishful thinking").
Such companies as Realogy, Freescale Semiconductor, and Harrah's all presumed their business models could handle the massive debt they incurred to finance their LBOs. The way these deals were structured, however, didn't leave much of a cushion. Of course, in the case of Harrah's, few would have expected a casino company actually to face business challenges. Until the current economic problems, the gaming industry had always appeared virtually recession-proof. Of course, a lot more capacity was added since the previous recession, and when revenues started to decline, things went bad quickly.
A good rule of thumb for LBOs is that if you don't have good timing, you should have some financial cushion. For whatever reason, this is one lesson with which the market hasn't quite come to terms.
Some Bright Spots
In Standard & Poor's Ratings Services' review of the largest rated LBOs of the past few years, there were a couple of success stories. Alltel Corp., for example, went from a post-LBO B+ corporate credit rating to an A, although that was due to its acquisition by Verizon (VZ), which had a stronger credit profile. We upgraded Knight (formerly Kinder Morgan) after it improved its post-LBO credit profile, and we had some firms that have not been downgraded since they completed their LBOs. Also, we revised our post-LBO negative rating outlooks on Aramark Corp., and HCA to stable, and we have maintained our stable rating outlooks on SunGard Data Systems and Intelstat, partly due to their steady, recurring cash flows and good revenue visibility.
|The Upgrades||The Stables||The Downgrades|
|ALLTEL Corp.||ARAMARK Corp.||CC Media Holdings Inc. (Clear Channel)|
|Knight Inc. (Kinder Morgan)||Energy Future Holdings Corp.||First Data Corp.|
|HCA Inc.||Freescale Semiconductor Inc.|
|Intelsat Ltd.||Harrah's Entertainment Inc.|
|SunGard Data Systems Inc.||Realogy Corp.|
|Station Casinos Inc.|
|Univision Communications Inc.|
Pushing Too Far—And Failing
It's hard to look at most recent LBOs as successful by any measure. In our view, only a few did pretty well and showed some progress from a credit quality perspective. But perhaps the fundamental takeaway from most of the deals done over the past few years is that they may have pushed things too far. They have come to represent the capital market excesses of the past five or six years. The "covenant-lite," "let's-take out a special dividend," or "let's see just how high we can leverage the deal" approaches probably sealed the fate of some of these LBOs long before the ink was dry on their agreements.
We have observed that many of these transactions fell prey to bad timing. However, anytime an LBO is structured for only the best of all possible worlds, chances are good that it is set up for failure. There is no question that difficulties arising from the current deep economic downturn are exacting a toll on LBOs done over the past couple of years.
From a credit standpoint, we believe that it didn't take much to put these deals in financial stress because they generally had such small margins of error. With leverage at 9 or 10 times debt to EBITDA or higher, a company, in our view, will have a difficult time surviving in anything but the most positive circumstances. In the early 1990s, defaults surged as a recession took its toll on many of the LBOs done just a few years earlier. We can expect the same now given the current recession.
The message seems very clear: Too much debt can be very risky.