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Distressed buyout debt worrisome for many

Monday, February 11, 2008

NEW YORK -- Homeowners aren't alone in experiencing buyers' remorse in today's troubled marketplace. Private-equity firms, too, are finding out their recent investments might not be worth what they paid for them.

Gone are the days when buyout shops could purchase a company, pile on debt for an initial fat payout for themselves and then quickly flip it for a big profit. The credit crisis has put a freeze on debt-laden dealmaking and is causing bond investors to shun the risky debt used to finance the takeovers.

That could jeopardize the returns seen on some deals -- which isn't just the buyout firms' problem. Investors from pension funds to endowments to financial institutions have plunged big money into private-equity funds.

It's also a problem for the banks that are stuck with billions of dollars in loans clogging their books that they've been unable to sell.

That's quite a change from the recent past when median returns topped 20 percent for buyout funds raised from 2000 to 2004, according to London-based Private Equity Intelligence. For pension funds in particular, these holdings outperformed their other investments 82 percent of the time when looking back over the last 10 years, Preqin data found.

Those returns caused a flood of cash to flow into buyout funds, which raised an aggregate $210 billion in 2007, on top of the $233 billion raised the year before, Preqin found.

That money, along with easy access to cheap debt financing, fueled the record-setting pace of dealmaking in recent years. But triggered by surging defaults on home loans, lenders have tightened the credit tap for businesses and consumers, and that's spurred a flight to quality by debt-market investors.

"People are worried that the economy is facing a difficult time," said Steve Miller, managing director at Standard & Poor's Leveraged Commentary & Data. So "investors have repriced risk to cushion if default rates start to really go up."

That's most evident in leveraged loans, which are issued by banks and sold to investors much like junk bonds. They are often used to fund leveraged buyouts, but given the downturn in investor interest, the banks have been left with $150 billion overhang of LBO debt on their books.

Morgan Stanley's chief financial officer Colm Kelleher told an investor conference on Wednesday that the investment firm's $20 billion of leveraged-buyout loan commitments are its "top concern right now," according to a transcript provided by Thomson Financial.

At the same time, much of the LBO debt trading in the marketplace has been plunging in value, suggesting a buyers' strike by investors worried about how close we are to the bottom of the credit crisis. The tumbling prices can also indicate that investors are worried that bankruptcy could loom at some companies.

The Distressed Debt Investor found that 29 percent of 176 bonds and loans tied to U.S. LBOs from 2002 through the third quarter of last year, when this market began to seize up, are trading at distressed levels. Those are bonds with option-adjusted spreads at least 10 percentage points above Treasury yields or loans trading at 90 cents or less on the dollar.

That's way ahead of the nearly 19 percent level of distress seen in the broad-market Merrill Lynch Master II High-Yield Index, according to the publication put out by FridsonVision.

One example is Claire's Stores, which was taken private by Apollo Management in a $3 billion deal last May. The Pembroke Pines, Fla., jewelry and accessories retailer's bonds have slumped in recent months, amid a weakness in its sales.

Its senior notes due in 2015 have plunged 33 percent to trade around 67 cents on the dollar. And its subordinated notes are trading around 48 cents on the dollar, according to bond research firm KDP Advisor in Montpelier, Vt., which is recommending its clients sell their Claire's Stores' debt.

The price of Tribune Co.'s debt is also sharply lower; weakening economic conditions are knocking down advertising revenue throughout the newspaper industry. The media company, taken private by investor Sam Zell for $8.2 billion in a deal that closed in December, issued $5.15 billion in loans that are now trading at about a 27 percent discount, according to S&P LCD.

Zell's investment in Tribune was $315 million and he owns warrants to buy about 40 percent of the company, which will be formally owned by an employee stock ownership plan.

Many others, including data processor First Data Corp., real estate broker Realogy Corp. and Freescale Semiconductor Inc., have also seen their LBO debt battered in recent months.

The plunging prices don't put the buyout firms in a good spot. Many made their purchases at the height of the buyout boom, making it questionable if they'll ever see their original valuations again.

Some will likely try to wait out the market's storm before they try to sell the investments off, but others might not have that luxury. That's where this could get ugly -- for all of us.


Rachel Beck is the national business columnist for The Associated Press. Write to her at rbeck(at)ap.org


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