Private Equity's Big Debt Burden

Some analysts say plenty of positives offset the risk. Others predict a wave of defaults by firms crippled with debt

by Steve Rosenbush

Private equity's torrid buyout binge has lenders rewriting the rules of debt, with firms borrowing once unimaginable sums to pay for their record deals.

As recently as 2004, the average buyout was funded with $4.50 of debt for every dollar of a target's cash flow. No longer. Now average debt levels are a record 5.9 times cash flow, and debt multiples of eight or nine times are common. The changes have been driven by a number of factors, including low interest rates, cash-flush lenders, and the belief that healthy corporate earnings and cutting-edge management mitigate risk.

Soaring Debt Ratios

In April, Chicago real estate mogul Sam Zell shocked many observers with his $8.2 billion deal for media giant Tribune (TRB) (see BusinessWeek.com 4/2/07, "Zell's Big Plan for Tribune"). The astonishment wasn't from the price so much as from the structure of the deal, which involves a two-part plan to acquire outstanding shares and will leave the company with as much as $13 billion in debt—10 times its cash flow.

And just last week, TPG Group and GS Capital Partners, a unit of Goldman Sachs (GS), announced that they would take Arkansas-based telecom Alltel (AT) private in a $27.5 billion deal (see BusinessWeek.com, 5/21/07, "Private Equity Dials Up Alltel"). The company's debt ratio will rise to about eight times earnings before interest, taxes, depreciation, and amortization, or EBITDA, according to analysts.

Debating Default Prospects

An increasing number of investors, including private equity pioneer Wilbur Ross Jr., argue that a big wave of credit defaults is forming at the lower depths of the junk-bond market. "I think default rates will go up a lot," says Ross, who became a billionaire by investing in distressed industries such as steel and auto parts (see BusinessWeek.com 5/15/07, "Wilbur Ross: No Chapter 11 Here"). "We think they will at least double by the end of this year and at least double or triple by the end of next year."

Not everyone is so sure the default rate is about to spike. They contend that higher leverage ratios are acceptable because low interest rates and a healthy business environment mean that many stronger companies can afford to take on high debt without incurring unmanageable risk. "A path to higher risk and leverage is visible for the corporate sector amid the private equity buying binge. However, this remains a path to be trod," Citigroup (C) analyst Steven Wieting said in a May 18 report, "Leverage & Growth—Get Used to Them Both."

One hedge fund manager agrees. He says even weaker companies can live with high debt, at least for now. For the moment, they face few loan conditions that can trigger a default—and if they get into trouble, someone else lends them more money. "I see a tremendous amount of liquidity in the financial system and no signs of it drying up," says Ralph Rosenberg of R6 Capital in New York. "Even if companies hit 'speed bumps,' it will be a while before they run into problems with their lenders. I think the only thing that changes this is if there is complete repricing of risk across all asset classes—debt, equity, real estate, etc." Such a scenario could come in the form of a terrorist attack or some other cataclysmic event, Rosenberg says.