The Dark Side of the M&A Boom

It has been financed by a flood of junk bonds. Defaults have been low, but that may not last, especially in automotive, health care, and telecom

by Steve Rosenbush

Earlier this year, buyout giants Kohlberg Kravis Roberts struck an agreement for a $33 billion leveraged buyout of hospital company HCA (HCA). The deal is the largest buyout ever, eclipsing KKR's record purchase of RJR Nabisco in 1988. That deal was worth $31.4 billion, including debt.

The HCA deal was hardly an anomaly. This year has broken 2000's record for private-equity fundraising, according to industry newsletter Dow Jones Private Equity Analyst (see BusinessWeek.com, 11/7/06, "The Money Behind the Private Equity Boom")—and it isn't even over. U.S. private-equity funds have raised $177.89 billion in 2006 to date.

Not even KKR can afford to write checks to fund such big deals. The equity portion of the transactions, raised from pension funds and other limited partners, usually covers 20% to 30% of the purchase price. The rest of the money comes from issuing debt, often the high-yield variety commonly known as "junk."

Record High-Yield Debt

Mirroring the rise in deal volume and deal price, the issue of global high-yield debt has also hit a new high this year. On Nov. 9, researcher Dealogic said that high-yield debt hit a record $211.7 billion, breaking the $210.8 billion record set in 2004. Total volume in the U.S. is $99 billion. That's below the domestic record of $118 billion set in 2003, although the size of individual deals in the U.S. is breaking records.

HCA is one of the big reasons for the surge. On Nov. 9, the company issued $5.7 billion in high-yield bonds in what appears to be the second-largest high-yield offering, behind the $5.73 billion NXP Semiconductor deal earlier this year. A new record is expected to be set next week as Freescale Semiconductor (FSL) issues an anticipated $6.15 billion in high-yield debt (see BusinessWeek.com, 9/12/06, "Bidding on Freescale Sets Off Alarms").

Some investors are concerned that the rise in junk-bond debt will have unpleasant consequences. The level of distressed debt and the level of companies that actually default on their obligations to creditors are both expected to rise.

The Sectors At Risk

That doesn't mean an economic crisis is at hand, although some senior financial executives who decline to be identified believe that such an occurrence is possible three or more years down the road. The default rate is currently 1.27%, well below the long-term average of 4.7%, according to Standard & Poor's distressed debt analyst Diane Vazza. She expects the default rate to start inching higher, although it's likely remain below the average for the foreseeable future. And it's nowhere near the 10% that was hit during 2001, as the tech bubble turned to the tech crash.

Looking ahead, Vazza expects the default rate to hit 1.4% by the end of this year, 2.6% by the first quarter of next year, and 3.47% by the end of next year. Why won't it spike higher between now and early 2008? "The reason is that we're still looking for a soft landing in the economy. We expect profits to slow and default rates to inch up," she says. She doesn't forecast further into the future.

The rise in the default rate and the rate of distressed debt will affect particular sectors more than others. Who's at risk? Some companies pay the very highest of high yields, which are at least 10 percentage points above the current Treasury rate of 4.63%. That's the classic definition of "distressed," Vazza says. But she also studies companies that pay six or eight percentage points above Treasuries. The sectors with higher rates include automotive, health care, and telecom. Telecom upstart Level Three (LVLT) pays as much as 12%, although CEO Jim Crowe said he expects to refinance that debt at lower rates thanks to the financial benefits of a plan to acquire Broadwing (see BusinessWeek.com, 10/18/06, "Level 3 Elopes with Broadwing").

Credit Confusion Possible

Some companies in the forest products and building materials sectors also show signs of distress, paying eight percentage points over Treasuries. Some retail and restaurant companies pay six percentage points above Treasuries, which also can be viewed by some as a sign of distress. In the past, a rise in debt levels and deal prices has led to rising default rates. "The market appears as though it is setting itself up for correction," says Jeff Williams, of investment bank Jeff Williams & Co.

A correction could create confusion because the credit markets have been flooded with new kinds of securities. Sometimes it isn't quite clear who is supposed to get paid first. "People have sliced and diced the credit stack. It isn't as clear as it used to be, and it could take time work out the relationship between those securities," Williams says.

A rise in the rates of distress and default isn't good for creditors. In extreme situations, it can cost hundreds of thousands of lost jobs, hurting the economy as it did in 2001. But there will be some people who profit. For investors who take an interest in distressed debt, this is the preseason warmup.

Rosenbush is a senior writer for BusinessWeek.com in New York.