|
|
|
ONLINE FEATURES
Book Reviews
BW Video
Columnists
Interactive Gallery
Newsletters
Past Covers
Philanthropy
Podcasts
Special Reports
BLOGS
Auto Beat
Bangalore Tigers
Blogspotting
Brand New Day
Byte of the Apple
Economics Unbound
Eye on Asia
Fine On Media
Green Biz
Hot Property
Investing Insights
Management IQ
NEXT: Innovation
NussbaumOnDesign
Tech Beat
Working Parents
TECHNOLOGY
J.D. Power Ratings
Product Reviews
Tech Stats
Wildstrom: Tech Maven
AUTOS
Home Page
Auto Reviews
Classic Cars
Car Care & Safety
Hybrids
INNOVATION
& DESIGN Home Page Architecture Brand Equity Auto Design Game Room SMALLBIZ Smart Answers Success Stories Today's Tip INVESTING Investing: Europe Annual Reports BW 50 S&P Picks & Pans Stock Screeners Free S&P Stock Report SCOREBOARDS Hot Growth 100 Mutual Funds Info Tech 100 S&P 500 B-SCHOOLS Undergrad Programs MBA Blogs MBA Profiles MBA Rankings Who's Hiring Grads |  |
JANUARY 31, 2005
Loading Up On Junk With IPOs slow, buyout firms are selling junk bonds to recoup lots of their cash For years after the stock market drop in 2000, private equity firms found themselves locked into their investments with little hope of getting their money out. Their usual exit route, an initial public offering, was effectively closed. But now a combination of cheap money, better corporate cash flow, and a hunt for higher interest rate yields by institutional investors, such as banks, insurers, pension and mutual funds, is providing them with a new escape hatch. Private equity firms including Thomas H. Lee Partners, Blackstone Group, and Kohlberg Kravis Roberts are increasingly taking big slugs of cash out of the companies they own by getting them to issue junk bonds and then use the proceeds to pay out big dividends. This loads yet more debt onto companies that are often already highly leveraged, but it is proving irresistible to the firms. In December, for example, mattress maker Simmons Co. sold $165 million of nearly distressed debt in the market and then paid out a special dividend to Lee and its partners. The sum returned is more than 40% of the $388 million the group had put down just 12 months earlier when it purchased Simmons in a $1.1 billion leveraged buyout. The deal went a long way toward making up for the payout the Lee group failed to collect in July when it withdrew a planned IPO of Simmons after the equity market cooled. And Lee still owns 100% of Simmons. Such cash-out borrowings, more formally known as dividend recapitalizations, are surging in popularity. Last year 77 dividends, worth $13.5 billion, were financed by junk-bond market deals, up from 26 worth $6 billion in 2003 and just nine worth $2 billion in '02, according to Jim Casey, an investment banker in charge of the high-yield department at J.P. Morgan Chase & Co. (JPM ). Highly leveraged loans from banks raised another $9.4 billion for dividends in 2004, three times as much as the year before, according to LCD, a unit of Standard & Poor's (MHP ) that tracks the leveraged loan market. "When a market develops like this, the bankers all swarm in" to make deals, says one buyout executive. Several factors are driving the trend. Demand for corporate debt is red-hot because yields on U.S. government debt are so low. In fact, demand for junk bonds is so intense that the interest-rate premium borrowers must pay over what investors can earn by buying Treasuries is the lowest in at least six years. Improving corporate cash flow is reassuring investors that borrowers will be able to repay loans. And for the firms, the government's decision to slash taxes on dividends to the same 15% rates as on long-term capital gains means it is easier to net a payout that is as good as it would be from an IPO. But the deals come at a price. They pile more debt, and more risk of default, on businesses that the equity firms leveraged when they bought them in the first place. In fact, some observers believe that dividend recaps could become the hallmark of excess in the current bull market in junk bonds. Martin Fridson, chief executive of FridsonVision LLC, a high-yield market research service, says the deals are the most prominent new source of supply that bankers have found to feed a new generation of yield-hungry investors. John Lonski, chief economist at Moody's Investors Service, says that in 20 years of watching the junk-bond market he has never seen so many leveraged payouts contributing to so many credit downgrades: 17 in the fourth quarter of 2004. "A significant number of these lower-rated companies will default within the next five years," says Lonski. Naturally, bankers and private equity firms aren't so downbeat. J.P. Morgan's Casey counters that dividend payouts were behind only 8% of the new junk bonds issued last year and a much smaller factor in today's market than were the telecom deals and LBOs of past bull markets. And Lee co-president Scott A. Schoen says his firm has taken advantage of the hot market to borrow only against improving businesses generating enough cash to eventually pay off the extra debt. "We take these opportunities without adding a lot of incremental risk to the companies," says Schoen. FANCY STRUCTURES All the same, bankers and private equity firms know that to keep doing the deals and financing the payouts they'll have to be careful to control risk as they add debt. To do that, they've been coming up with increasingly complex securities to minimize interest payments in the early years of loans, thus postponing any days of reckoning. Consider the $700 million package of new debt issued on Dec. 23 by WMG Holdings Corp., parent of Warner Music Group, which was bought in a leveraged $2.6 billion deal a year ago from Time Warner Inc. (TWX ) by a group including former Seagram Co. Chief Edgar Bronfman Jr. and equity firms Lee, Bain Capital and Providence Equity Partners. One $250 million slice of the debt offers a yield of 9.5% a year but with no interest actually being paid for the first five years of its 10-year life. Holders of another $200 million tranche of the debt won't get any cash payout until that part of the loan matures in 10 years time. In effect, buyers of the debt get to accrue interest before the company ever has to pay it. What's more, the new debt was issued through a holding company, so that it would have a weaker claim on the assets of the business than the $2 billion of debt Warner Music already carries. The fancy structure in the Warner deal apparently helped because Moody's did not downgrade the company's existing debt. But Moody's did assign a negative outlook on it. For one thing, it was the second time that Bronfman, Lee, and partners had taken cash out of the company. Having paid themselves $350 million in October from cash built up from operations, the investors have now recouped all of the $1 billion of cash they put up for the buyout a year ago. Lee's Schoen says that while he's happy with the company's performance and the cash from the market, the investor group remains at risk. "All of our profits are still invested in the company," he says. CLAMORING FOR BONDS Still, institutional portfolio managers holding debt do not like to see the private equity firms getting their original stake back so quickly after buying a company. "Now they're sort of playing with other people's money," says Fridson. The fear is that the owners will then be tempted to take too many risks now that their original outlay has been returned to them. But Fridson concedes that such misgivings are not stopping institutions from clamoring to buy new bonds, even those of companies that already owe them a lot of money. The fact is, the portfolio managers have a lot of capital their clients expect them to invest in the market, so they hold their noses and buy more bonds. Of course, a spectacular default could bring the market to a grinding halt. In that case, the portfolio managers' clients would likely rush to pull out their investments, thus cutting off the source of funds that are being used to pay special dividends. Events may not come to such a pass. After all, the IPO market is picking up and once again bringing buyout firms' traditional exit strategy back within reach. Investors led by Blackstone Group were looking in mid-January toward a $1.2 billion stock offering for a cluster of entities they've assembled around the chemical giant formerly called Celanese AG, which they bought last April. Although Blackstone had already taken out $638 million from junk sales last year, the investors were looking for an additional $950 million payout from the IPO and some additional borrowing. If deals like that work, stock investors may save the junk-bond market from itself.  By David Henry in New York
BW MALL
SPONSORED LINKS
Get BusinessWeek directly on your desktop with our RSS feeds.
Buy a link now! Add BusinessWeek news to your Web site with our headline feed. Click to buy an e-print or reprint of a BusinessWeek or BusinessWeek Online story or video. To subscribe online to BusinessWeek magazine, please click here. Learn more, go to the BusinessWeekOnline home page  | | |
 Copyright 2005, by The McGraw-Hill Companies Inc. All rights reserved.Terms of Use | Privacy Notice |
Printer-Friendly Version
