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KKR: A Deal Too Far?


Could the deal for First Data Corp. mark the beginning of the end of the private equity boom? Wall Street is watching closely.

Kohlberg Kravis Roberts & Co.'s $29 billion bid for the credit-card processor is testing just how much appetite investors have for increasingly large and risky leveraged buyouts (page 110). To pull it off, KKR must push $8 billion of junk bonds, the most ever sold in a single chunk, along with a record $14 billion of a type of speculative loan marked by ultraweak protections for investors. If KKR falters, Greg Peters, credit strategist at Morgan Stanley (MS), cautioned clients, we could hear the "sucking sound" of the easy money draining out of the markets--capital that has not only been funding the buyout binge but also supporting corporate buybacks and stocks. KKR declined to comment.

In some ways the buyout of First Data looks a lot like that of SunGard Data Systems, the $11 billion deal that kicked off the boom back in early 2005. That deal, like this one, was dubbed the largest buyout of a technology company. Both companies have steady revenue streams.

But a closer comparison reveals just how much more bond investors are being asked to swallow two years later. Besides being bigger, the First Data buyout is a lot riskier. Consider a key measure of leverage in such deals, total debt to cash flow. First Data's is expected to be around 10, vs. 7 for SunGard. At the same time, First Data's cash flow will just barely cover the interest expense on its bond and loans. SunGard has more than half of its cash flow left over, giving it a cushion in case business slows or the company needs to make a critical investment.

Meanwhile, KKR is footing only 25% of the bill for the First Data buyout. A consortium of private equity players including KKR put up 31% of the equity in SunGard's case. And KKR wants to fund this latest deal through a whole bunch of speculative loans with loose terms for the borrower, a sort of debt virtually unheard of when the SunGard deal was financed. Although credit-rating agencies haven't yet reviewed the deal, KDP Investment Advisors Inc. figures First Data will get downgraded to a B- or CCC+, making it junkier than SunGard's already shaky rating of B+.

Credit quality has been declining broadly as the boom has gained steam. The average debt on large LBOs was 4.8 times cash flow in 2004. Now it's around 6.3, according to Standard & Poor's LCD, a loan-market research service. Back then, companies' free cash flow was more than double their interest expense, vs. just 1.6 times higher today. And those ultra-risky loans will account for 19% of the total loan market if the First Data deal goes through, up from essentially none two years ago.

Ever bigger and riskier deals eventually proved to be the death of the 1980s boom. On Oct. 13, 1989, financing collapsed for the $6.8 billion buyout of United Airlines Inc.'s (UAUA) parent. As debt investors retrenched, dealmaking stopped, and the stock market plunged 7% in a day. "There will be a point when there is a buyers' strike," says John F. Addeo, a portfolio manager at MFS Investment Management. "This will end badly."

MOODINESS

KKR, which should start marketing the deal in July, will likely argue that First Data will have higher cash flow in the future, making it a safer bet than it seems. And as long as the credit picture overall remains solid, investors will probably bite. But the mood can change quickly if the economy sours or interest rates rise. In that case, KKR may find it hard to convince folks that First Data can comfortably cover its interest expense. Even a half-point increase in rates can make a difference.

Meanwhile, there's plenty of competition for investors' dollars. According to Richard J. Peterson, director of capital markets at Thomson Financial (TOC), private equity firms are looking to borrow an additional $180 billion to fund a handful of looming deals. Some of the proposed debt loads are mega-size: $23 billion for telecomunications company Alltel Corp. (AT) and $37 billion for TXU (TXU), the Texas-based utility. "Whether KKR can price this deal two months from now is a big question," Kingman Penniman, CEO of KDP, says. "We may be at a turning point."

By David Henry


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