Battening Down for a Credit Crunch: Leveraged players look to ease debt loads and trim purchase prices

For the last three years, dealmakers have been riding a wave of liquidity that made financing acquisitions the least of their worries. While deals faced other hurdles during this period, it was a rare transaction that floundered because buyers couldn’t arrange financing. “It’s been an extraordinarily benign lending environment. Buyers have had access to cheap money and lenders have been increasingly tolerant,” says David Stowell, a finance professor at Northwestern University’s Kellogg School of Management. But just as every party has to end, experts say, a credit crunch is on the way. To gauge how soon it’s coming and how it will impact future deals, Mergers & Acquisitions talked to debt professionals and others about how dealmakers can best ride out the expected decline in credit availability and the stiffer terms it’s likely to trigger. “We’ll see an end to the era of easy financing terms for deals. The only question is when it will end,” says one unidentified attorney who works with private equity buyers. When the squeeze comes, dealmakers expect a slowdown in deal flow, lower prices, increased difficulties for private equity players to exit their holdings, and an edge to well-heeled strategic buyers, as well as more contentious workouts for those companies that get into trouble. Some deal and debt pros who already are hunkering down suggest that buyers get more choosy about pricing, craft more flexible and less burdensome deal structures, and select lenders that are most likely to be understanding in a pinch. A reverse tide to traditional banks from hard-nosed alternative lenders is a strong possibility. There are lessons to be learned for both strategic and financial buyers about the best response to the expected tightening of the credit cycle. But there’s no denying that the most telling adjustments that will grow out of an environment of decreased liquidity must be made by private equity buyers. They are the buyers who make their acquisitions by loading up targets with as much debt, or leverage, as the businesses can support. In addition to relying on traditional funding sources, private equity buyers have come to rely on so-called “leveraged loans.” These floating-rate loans are rated as junk, but they’ve performed well over the last decade a far as repayment of interest and principal are concerned. This has caused a new class of alternative lenders, including hedge funds, to enter the business of financing M&A. Competition among these lenders and the more traditional financial credit sources such as banks has led to lower rates and fewer restrictions on loans. Fueled by this credit abundance, private equity buyers have been busy. According to Private Equity Intelligence, a London-based research firm, there is more than $700 billion available for worldwide PE investment. In the United States alone, completed deals by American PE firms for the first six months of this year are up 96% over first-half 2005 totals – to $104 billion, according to the ZEPHYR database. But this has prompted a fallout question by experts. They are asking whether any of the highly leveraged North American megadeals, many of them big-ticket club deals, will find themselves struggling with too much debt in a more restrictive environment where floating-rate debt costs move to the upside. A centerpiece for these formats was the $11.3 billion acquisition of financial software and disaster recovery specialist SunGard Data Systems Inc. in 2005 by a group of PE firms led by Silver Lake Partners. Early Glimpses of a Downturn One private equity debt professional says that market observers may have been able to see the start of a turn in the credit cycle at the end of June. “We’re seeing a glimmer of a change now,” he said in early July, predicting that dealmakers soon could see more evidence of a downturn in credit availability. Let’s run through some of factors that lead observers to forecast the end of the period of massive liquidity. In macroeconomic terms, analysts point to the likelihood of a stagnant stock market, weaker economic growth, depressed earnings, and the possibility of some external systemic shock to the economic system as factors that could combine to dry up liquidity. Dick Bove, a financial institutions analyst at Punk, Ziegel & Co., says that one place trouble may come from is the Far East. “You can’t just keep adding capacity in China indefinitely without some repercussions,” he says. One other supporting factor for the expectation of reduced credit availability is the fact that central banks across the globe are raising interest rates. In June the Federal Reserve raised the benchmark short-term rate for the seventeenth time by a quarter point to 5.25%. If inflation were to put the brakes on economic growth despite these rate hikes, it also would increase the likelihood of less liquidity. Another key marker is the default rate for corporate high-yield bonds, which is at the lowest level – 1.09% – in more than 20 years, according to Standard & Poor’s. That can’t last, and there is only one direction – upward – that this indicator will move, the experts believe. This matters because the issuance of high-yield debt and leveraged loans is key to private equity deals, and these markets traditionally are weakened by an increase in the volume of corporate defaults. The combination of low interest rates, a tiny high-yield default rate, and low valuations have formed the underpinnings of the easy access to credit that financial buyers have enjoyed. But there are warning signs of potential storms on the horizon, possibly by summer’s end, but no later than early next year, the debt experts report. The results of a poll done in June by the Turnaround Management Association show that its members foresee debt default rates increasing in the near term for underperforming, highly leveraged companies. Ninety percent of the respondents expect that rude awakening by the end of 2007, with 60% believing a blow-up could occur as early as mid-2007. Dr. Edward Altman, a professor of finance at the Stern School of Business at New York University, stated in a release that he expected an even more rapid escalation in defaults. Based on his research in the dynamics of high-yield and distressed debt markets, he expects default rates to increase significantly in the first quarter of 2007. In June, KPMG published a survey that queried private equity professionals in Europe about whether some recent PE deals were overleveraged and likely to cause problems in the market. Seventy percent of the respondents said they expected to see some overleveraged deals fail. Yet another worrisome indicator threatening financing conditions is the increase in debt multiples that private equity buyers are paying. As recently as two years ago, many deals were done at four times underlying earnings; this year a number of transactions have been priced at as much as seven and eight times earnings. Altman indicates that when multiples rise above six, they can contribute to an increased default rate, unless the debt load is reduced in the two to four years after the deal is completed. In more anecdotal terms, debt professionals point to two recent Goldman Sachs hires. In the U.S., Goldman hired bankruptcy lawyer James Sprayregen from Kirkland & Ellis to run its restructuring business. His hiring has been read by debt authorities as an indication that Goldman expects an increase in distressed situations. In Europe, the firm also hired Lachlan Edwards, formerly head of European restructuring at Rothschild, to oversee its European distressed debt operations. But for all this doom predicting, there are debt professionals who say that because of the sophistication of the debt markets and use of new instruments like collateralized debt obligations (CDOs) and second-lien loans, the risk of a wave of defaults and an accompanying credit crunch is slight. Even if experts don’t agree or can’t predict when the downturn will come, there is more unanimity about what some of the characteristics of the winter of liquidity will be. University of Florida finance professor Jay Ritter notes that follow-on effects of the credit cycle’s downturn will include a drop in deal volume, lower purchase prices, lower multiples in private equity deals, and new opportunities for strategic buyers. Traditional wisdom has held that corporate buyers can afford to pay more in all environments. There is some evidence that this wasn’t true while debt was easily available. But as leverage becomes more expensive, this principle should reassert itself. While some analysts say that the big club deals such as SunGard could be victims of the turn of the cycle, others believe that the LBOs done by such PE giants as Kohlberg Kravis Roberts, Texas Pacific Group, Blackstone Group, and their peers will be OK. “The largest PE firms have structured their deals with enough protection to allow them to ride out a downturn,” says the aforementioned private equity lawyer. “The big club deals were done at the best possible rates, so they’re not going to be at risk.” But this lawyer says he believes that it will be the “non-headline LBOs” that could face trouble. Smaller deals done by nimble financial buyers are also likely to survive in a harsher debt environment, he says, but the most likely victims of the downturn are middle-market PE transactions. “At the top and the bottom, I don’t expect much trouble,” he says. “However, it’s at the mid-market firms, especially those stretching to compete with juggernauts like KKR and Blackstone, where the train wrecks will occur.” Another not-so-distant early warning sign of the cycle’s turn, according to the unidentified PE professional, is the closing of the window for recaps – financial restructurings to bring in capital, improve operations, and enhance performance at portfolio companies. They may or may not involve new debt or a change in ownership. This professional says that when the tightening comes, there will be a widening of spreads and investors will become more discriminating about the kinds of businesses they will back. He also expects to see lower prices for assets. Stowell says that as liquidity dries up it will kill off the secondary private equity market – sales of companies from one PE group to another – because exit multiples will shrink. Also expected to be at risk will be a new component of many deal structures, second lien loans. The private equity legal counsel says he expects to see a lot of second-lien loans go bust. Another debt expert, John Brignola, an Executive Vice President at LBC Credit Partners, says he expects second-lien loans to be a “wild card” as credit dries up. “Many of the larger second-lien loans contain liberal terms and have been syndicated to numerous lenders, many of which are new players, so it’s hard to predict how much downside they represent,” he says. There will also be an increase in interest rate swaps, says Colin Cross, a Senior Managing Director at Crystal Capital. He says the swaps should allow some portfolio companies to ride out the storm of less liquidity and raising rates. Cross also foresees tightening covenants and a change in debt-to-equity ratios with the move in the direction of buyers having to increase the slug of equity they must put into their deals. Lessons of 1989 Another topic deal mavens are pondering is how much the debt crunch this time around will resemble the last debt meltdown. Many debt professionals see the markets as a whole being able to adjust to an increase in default rates and associated follow-on effects with much more ease than the market displayed during the junk-bond massacre and resulting credit crunch that began in 1989. Brignola predicts a “moderate downturn,” noting that the composition of the loan market is different than it was in 1989. “The roles are reversed,” he says. “In 1989, about 75% of the leveraged loans were held by banks. Now the so-called alternative lenders hold 75% of the debt.” Many debt pros say that since these obligations have been farmed out in the shape of CDOs, there is less chance of a shock to the system. Another comforting factor for forecasters is that today’s LBOs aren’t as leveraged as were the most ambitious deals of 17 years ago. The $27 billion RJR Nabisco Inc. buyout by KKR in 1989, still the largest LBO in history, was done with a much higher debt-to-equity ratio – in the 90/10 range – than today’s deals. Bradley Charchut, a Director at Dymas Capital Management, says that if we were to see a perfect storm of negative developments, one ominous result would be the overall drying up of capital. Charchut and others note that the market could adjust to increasing rates for borrowing but it would be in trouble if there were no capital to be had at any price. He adds that for now, at least, capital providers seem to have deep pockets and little hesitation to put their money to work. The private equity lawyer says that as long as corporate profits remain strong, changes in the availability of debt will have a muted effect on the system. On the negative side, Ritter points out that the 1989 default wave didn’t start from such a low interest rate environment as we’ve seen in recent years. This could make dislocations more severe, he suggests. He also partially rebuts those who argue that the increased rate of syndication of deal loans should make for a softer landing as the debt cycle contracts. “Even if you slice it and dice it, it shifts the risk, but doesn’t eliminate it,” he says. “If things go bad, somebody’s still going to be holding that toxic waste.” Workout Nightmares But even as some dealmakers and debt professionals tend to downplay the severity of the effects of the change in the debt cycle, most agree that for those companies that are weakened enough to need restructuring, it will be uglier this time around. The PE attorney says he expects to see major valuation fights between tranche B, or second-lien lenders, and unsecured and equity holders in any workouts that are created by a shift in the debt cycle, while Brignola expects coming workouts to be longer, more challenging, and more complex. One reason for the grim prognosis is the participation of alternative lenders in deal structures. These lenders, including hedge funds, have largely supplanted banks as providers of loans to PE buyers. “These aren’t players who care about relationships,” the private equity lawyer states. Many of the alternative lenders, he adds, are not concerned about getting the next deal that one of the big private equity firms might offer them in return for some degree of forbearance in the workout of a portfolio company. The private equity debt professional agrees that there are more holders of paper who are unconcerned with relationships. “PE investors and lenders have basically diminished the value of relationships,” he says. “They’ve come to treat the source of capital as nothing but meat. They will reap that harvest.” Preparing for the New Cycle The way for dealmakers to prepare for the expected credit crunch is to create enough flexibility in deal structures so that borrowers will have sufficient capital to withstand the reduction in liquidity. Sponsors will need to make sure their companies have adequate capital to withstand a protracted downturn. This may include adding more liquidity themselves to the companies’ capital structure. “M&A professionals should make sure they build in enough liquidity, enough borrowing capacity under their lines of credit to weather a storm,” Brignola says. “Deal sponsors will have to choose between remedies such as making additional cash contributions or using less leverage.” Cross notes that among the new class of alternative lenders are some companies whose approach to the business he describes as “loan to own.” He advises deal pros to avoid this type of lender since their goal in any workout often can be the worst result for a company’s owners. For his part, Charchut advises dealmakers to design the appropriate debt structure for each company as opposed to falling into the trap of hearing about market multiples and applying them in a regimented fashion. Cross also says that borrowers should know their lender, stating that “people do all kinds of due diligence on every other aspect of a deal, but often they don’t check out their lender.” He suggests that deal principals assume there will be a problem when they structure their transactions, as counterintuitive as that may seem. If they vet prospective deals from this perspective, they may conclude that it’s worth a premium to be able to trust their lender rather than go with the cheapest guy in town, he notes. (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com