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Jumping on the bandwagon
A wave of leveraged buyouts is on the horizon, but while private equity firms, investment banks and high-yield investors are rubbing their hands at the prospect of a raft of new opportunities, investment-grade bondholders fear they might end up paying the price. Lisa Cooper reports.
ith share prices struggling, interest rates at rock bottom and companies looking to spin off non-core businesses, it was only a matter of time before the leveraged buyout (LBO) returned in force. Observers say the situation now is reminiscent of the late 1980s when LBOs – the tactic of using borrowed money secured against a target company’s assets to launch a takeover – exploded in the US. David Aberle, credit analyst at Baring Asset Management in Boston, says: “Equity valuations now look very similar to the values that led to the first round of LBO activity in the US in the late 1980s.” The trend started emerging over the summer: in August, Rodinheights bought Irish property company, Green Property, for more than €1 billion in a management buyout (different from an LBO in that the target firm’s management are involved in the buyout). The deal was backed with private equity from Merrill Lynch and Bank of Scotland. Another Irish company, packaging manufacturer Jefferson Smurfit, was acquired in late September for €4.5 billion by Madison Dearborn Capital Partners (MDCP) Acquisitions, an affiliate of the Chicagobased private equity firm Madison Dearborn. Other deals are in the pipeline. The private equity firms Kohlberg Kravis Roberts (KKR) and Wendel Investissement are buying Legrand, a French electrical equipment manufacturer, for €5 billion from parent company Schneider Electric. And bankers are working on LBO deals for airline catering company Gate Gourmet of Switzerland, Germany’s Haarmann & Reimer, which produces flavours and fragrances, and UK food distribution company Brake Brothers. This bustle of activity is not only welcome news for the mergers and acquisitions departments of
investment banks, which have struggled to justify themselves since the technology boom turned sour, but will also provide a much-needed boost to the European high-yield market. Analysts expect that deals totalling as much as €4.2 billion might come to the euro and sterling high-yield markets to finance US and European LBOs. In the first half of 2002 only €1.9 billion was raised in the European high-yield market and only £250 million in the sterling market. In fact, the LBO debt supply in September is so large that investment bankers are said to be trying to squeeze roadshows around one another, hoping that deals do not get overlooked with so many vying for investor attention. As Baring’s Aberle says: “The calendar is the busiest I’ve seen it for years.” Investors are also encouraged that many of the buyouts involve large private equity firms such as KKR, which was involved in the largest-ever LBO, the $25 billion acquisition of tobacco firm RJR Nabisco in 1989. “It is always good to see sponsors with deep pockets in case the deal goes awry and needs supporting,” says one high-yield fund manager in London. And more is expected. “There are still plenty of deals to be done on the lower end of the size spectrum, such as small regional companies with a very focused business and a good asset base,” says Marino Valensise, head of credit at Baring Asset Management. But as the saying goes, every silver lining has a cloud, so while high-yield investors welcome the new supply, not everyone in the investment community is happy about a resurgence in LBO activity. Holders of any bonds that the company may have issued in the past may see their investments dwindle as the company takes on substantial amounts of new debt to finance the buyout.
Elder, JPMorgan: credit protection now greater
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Of the firms with recent or imminent LBOs, both Jefferson Smurfit and Legrand have bonds outstanding. Jefferson Smurfit’s financing arm, Smurfit Funding, has a $250 million bond due 2005 and a $350 million bond due 2025. These will both become subordinate to the new debt. As a result Standard & Poor’s downgraded the company from BBB+ to BB+ at the start of September and left it on watch negative. Moody’s has kept the company on Baa2.
“The sterling market is dominated by a relatively small group of investors who can make or break a transaction”
Frances Hutchinson, HSBC
Legrand has a $400 million 30-year Yankee bond issued in 1995. Standard & Poor’s currently rates the notes A- and Moody’s Baa1, but both ratings are on review for possible downgrade. Xavier Buffon, S&P’s Legrand analyst, says that if the takeover is successful “a multi-notch downgrade is likely”, though he will not speculate on where the rating will end up. The acquisition of Legrand, due to close late this year, will use €2 billion of equity, €2.2 billion of senior bank debt and a €600 million high-yield bond issue. Howard Sharp, director, leveraged syndications at Royal Bank of Scotland, one of the banks involved in the deal, estimates that the bonds will be rated in the single-B range, Therefore any outstanding bonds will be downgraded to the same level. And while the outstanding bonds include a
change of control provision, this only takes effect in the event of a hostile takeover. With the management of parent company Schneider backing the deal, it does not qualify as hostile. Sharp says: “The bonds are non-callable, so we don’t have the option to refinance them.” But he admits that even if bondholders asked the company to redeem the debt, it would be unlikely to do so since it is not obliged to. Some investors are so incensed by the way existing bondholders can be treated when an LBO takes place that they are taking drastic action. “If any bank issues bonds in connection with an LBO and we already hold bonds in that company, we will question our trading levels with that bank,” says Bernard Hunter, director of fixed income at Merrill Lynch Investment Managers. “It’s a message we’ve made quite clear to our own counterparties and I know others have too,” Another senior London-based credit research analyst agrees: “Our high-yield investors would invest in new issues from leveraged buyouts, but not if this would hurt existing bondholders; just as I wouldn’t buy a stolen Rolex even though it wasn’t stolen from me.” He continues: “It should be bad business practice to advise companies on how they can shaft bondholders. If they are fair and reasonable with us, then we’ll be fair and reasonable with them.” Frances Hutchinson, head of European credit research at HSBC, says this policy can work. “The sterling market is dominated by a relatively small group of investors who can make or break a transaction,” she
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Illustration: David Lyttleton
says. “This allows institutional investors to have more influence on the terms and conditions of specific deals.” A recent example of the influence investors can wield in the UK is Green Property, which issued £150 million of investment-grade, fixed-rate bonds in December 2001. As a result of this summer’s LBO, the bonds were downgraded to sub-investment grade. However in this instance, existing investors should not find themselves out of pocket. When the bonds were launched in 2001 bond investors demanded comprehensive covenants because property companies had become frequent targets for takeovers and a previous attempt was made to buy out the company in 2000. The implementation of change of control covenants – which state that in the event of a takeover resulting in a downgrade of bonds below a specified level, the debt must be bought back and new bonds issued – means the debt is in the process of being redeemed. Green Property’s bond issue was joint-led by HSBC. HSBC’s Hutchinson says: “We have long been advocates of appropriate use of covenants, in particular change of control provisions.” She adds: “When we’re advising a potential borrower, it’s important that the debt is structured and priced appropriately. Issuers want the most efficient source of funding, while investors want the best deal. In the long run, it’s bad for the investment banks if deals are not structured properly or are detrimental to one group of investors. It leaves a bad taste in investors’ mouths.” One of the most notorious examples of existing bondholders getting a raw deal in a buyout was Nomura Principal Finance’s takeover of electrical appliance manufacturer Thorn for £1 billion in 1998 – the biggest LBO that year. In that instance, the existing senior unsecured debt was made subordinate to all new debt. Bondholders were left with junk bonds that effectively functioned as venture capital if the firm did badly, but would not benefit from the company doing well. “Although they didn’t break any laws or the letter of the bond documentation, it was a clear violation of the spirit of the bond covenants. You could call it daylight robbery,” says Bergqwist. Even the rumour of an LBO is enough to set a company’s bond spreads widening. For example, an article in a Sunday newspaper in 1998 hinted that a private equity firm was eyeing up the UK leisure and entertainment group Rank. The price of the company’s bonds dropped from 102 to 88 and their liquidity dried up. But Fergus Elder, managing director and co-head of loan capital markets at JPMorgan, which is involved in the Haarmann & Reimer and Brake Brothers LBOs this year, says times are different now. He believes it is unlikely that extreme examples like the Thorn deal will occur again. “I’d be very surprised to see something
like that happen now, as we’re in an era of greater credit protection. Most buyers would want to revamp the financing anyway and take out the senior bondholders. You really don’t want a recalcitrant bond group in an LBO, as there will always be some issue you need to tinker with, which will need both bank and bondholder approval.” Despite the examples outlined above, it must be stated that not all LBOs are evil. In Europe, only a small minority of companies undergoing an LBO actually have bonds outstanding. And when they do, this debt is not necessarily structurally subordinated. In most instances, existing bondholders will be bought out. And there are plenty of willing buyers of LBO debt in the European high-yield market, where banks and hedge funds are vying with fund managers. In the case of LBO financing, investors need to assess the type of business, the quality of the equity sponsor and the management plan. As most bond launches originating from LBOs are, by their very nature, large issues, any highyield investor would take an interest in them. For exam-
“You really don’t want a recalcitrant bond group in an LBO, as there will always be some issue you need to tinker with”
Fergus Elder, JPMorgan
ple, around €1 billion of notes were offered in September via Deutsche Bank and Merrill Lynch as part of the Jefferson Smurfit LBO. “No manager of a European high-yield portfolio can afford not to look at this. It is a big deal and will make up a sizeable portion of their index,” says Baring’s Valensise. However other investors insist that, unlike investment-grade debt, very few high-yield funds are actually managed against an index, so investment companies wanting to take a stand against what they see as unethical behaviour are free to do so. By refusing to participate in a deal in which existing bondholders will be penalised, investors hope they will be able to encourage better market practice for the future. A company’s attitude to its existing bondholders may depend on whether it is likely to need continued access to the bond market. If the firm needs to issue more bonds in future, it must be cautious in its treatment of existing investors so that they won’t refuse to participate in any forthcoming issues. As the Green Property example shows, covenants can help bondholders assert their rights. As well as the change of control clause, a second provision that can be beneficial is a negative pledge. This should ensure that senior unsecured debt remains senior and unsecured, and is not subordinated by assets being pledged to raise further debt finance. ■
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