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The Buyout Boom's Dark Side


There has been a lot of lamenting in recent months over the debt that private equity firms have been piling on companies. And there's even more worry over what will happen to those businesses when the buyout boom ends. If the story of Atlanta-based Spectrum Brands Inc. (SPC) is any indication, the fallout could be painful.

Pieced together over the years largely by prominent buyout firm Thomas H. Lee Partners, the conglomerate took advantage of the market's generous borrowing terms to fund an aggressive buying spree. But instead of transforming itself into a consumer brand powerhouse, Spectrum remains little more than a hodgepodge of middling brands, such as Rayovac batteries and Hot Shot insecticide. And serial dealmaking has left the company hobbled by a massive $2.5 billion debt load, one that is 10 times larger than Spectrum's value on the stock market.

Now the company has temporarily staved off creditors by refinancing its debt and putting one of its biggest divisions up for sale. In a last-ditch attempt to salvage their investment, the THL partners who sit on the board, along with the rest of the company's directors, have replaced Spectrum's longtime chief executive and other senior managers. Since March, 2005, the stock has dropped 90%, to 4.38. "This [investment] has been disappointing to us," says Scott M. Sperling, co-president of THL, the largest shareholder in Spectrum.

The destruction of capital and jobs at the company follows a history of wheeling and dealing—by THL and by Spectrum's executives, handpicked by THL—that goes back more than a decade. It's a history that shows just how much damage leveraged buyout firms can inflict on companies as they dress them up to sell to the stock market.

Spectrum's ability to keep tapping the credit markets depended in part on the magic of merger math to spread ever-increasing debt over more corporate assets, thereby creating the impression that the risk hadn't increased. Now, the depths to which Spectrum has fallen serve as a warning for others loaded up with debt in this era of easy money. Even more worrisome, troubled companies won't be able to make some of the same moves Spectrum did in March with its refinancing, given the recent squeeze in the credit markets. "The narcotic of doing deals and getting paid for it is pretty addictive," says Deutsche Bank (DB) analyst William Schmitz. "It works until it doesn't."

The story of Spectrum stretches back long before the buyout boom began. But it follows a trajectory remarkably similar to recent deals. In August, 1996, fresh off a big win with its three-year investment in Snapple Beverage Corp., THL scooped up battery maker Rayovac for $326 million, borrowing much of the money. Just 15 months later the buyout firm took Rayovac public again, and the stock nearly doubled in 13 months. THL gradually sold off most of its shares, distributing the last lot to its investors. It booked a fourfold gain on the deal.

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Butthl's relationship with Rayovac didn't end there. In January, 1999, THL bought United Industries Corp (SPC)., a 30-year-old garden fertilizer and insecticide manufacturer, for $652 million, putting up $255 million of its own money. At the same time, THL installed Rayovac Chief Executive David A. Jones as the company's chairman, his third assignment for the buyout firm. The goal: to have United's revenues grow to $1 billion in order to prepare it for a sale to the public. Between 2000 and 2004, United bought six businesses, including Canadian fertilizer vendor Nu-Gro Corp. and United Pet Group Inc., a maker of rawhide dog chews and aquariums. Debt rose to $860 million over that period. "They wanted to get the [sales] volume up as fast as they could," recalls a former United executive, who asked to remain anonymous.

It's the same borrow-and-buy philosophy Jones instilled at Rayovac, where he remained CEO. Rayovac picked up other battery brands like Europe's Varta and China's Ningbo Baowang Battery, and it added electric shavers to its list with Remington Products Co. (SPC) Rayovac's debt, meanwhile, quadrupled, to $800 million. Leverage "enabled us to take a relatively small company and grow the business significantly," recalls Kent J. Hussey, then the president of Rayovac and currently Spectrum's CEO. Jones declined to comment.

Leverage allowed United to do much the same. But despite its buying binge, United still lacked the scale THL thought it needed to cash out with a public offering. So THL came up with an alternative exit plan in early 2005: a $1.4 billion merger with Rayovac. "Given our experience with [Jones], we thought we could see good growth in the stock as we were exiting," says Sperling of THL, which kept a 25% stake in Spectrum.

Spectrum Brands, as it was christened, created a lot of buzz on Wall Street. Investors ate up the pitch that the newly merged company would be greater than the sum of its parts. Tossing around words like "synergies" and "diversification," management asserted that its bevy of brands, although largely unrelated, would give it more clout with retailers like Home Depot Inc. (HD) and Wal-Mart Stores Inc. (WMT) and allow it to operate more efficiently. The stock soared 50% in 10 weeks, nearly doubling the value of THL's initial investment to roughly $550 million. "We believed that there would be synergies, better performance, and all that," says Robert L. Caulk, former CEO of United Industries and later head of Spectrum's North American operations.

Spectrum's dealmaking continued apace. Just a couple months after the merger, management hit up the credit markets again, this time to buy fish food company Tetra Holdings from a group of other LBO firms in March, 2005.

Almost immediately the strategy started to unravel. With little room between deals, Spectrum struggled to get so many disparate businesses working together. At the same time, the battery business was clobbered by a spike in the cost of zinc. Management also had to switch gears on a key marketing and packaging initiative for its core Rayovac brand after the failed introduction of a value-sized pack of batteries. The misstep proved costly. Sales slipped, and the third-place brand lost ground to Duracell and Energizer Holdings Inc. (ENR) Operating profits dropped to $277 million in the four quarters through March, down 20% from 2005, according to research firm Capital IQ.

For its part, management has had a laundry list of reasons for its financial woes, which kicked off in July, 2005: Rising gas prices pinched pet owners' wallets. European consumers' preferences shifted away from its Varta batteries to low-margin private-label brands. And prices surged for the urea used in fertilizers. On July 12, Spectrum blamed part of its weak performance on the drought in the U.S. that crimped sales of its garden products.

Still, Spectrum might have been able to handle the ups and downs relatively well if it didn't also have to deal with so much debt. Shortly after Spectrum bought Tetra, debt stood at around 5.5 times operating profits, warranting a B+ junk rating. "There was very little margin for error," says Hussey. "We had to hit on all eight cylinders in order to make the plan work, and we ended up operating on six" because of unexpected headwinds in batteries.

There's even less margin today. In July, 2006, THL brought in workout specialists from Goldman, Sachs & Co. (GS) to help. And it's looking to dismantle the conglomerate it spent so many years and so many dollars building up. Management announced plans in February to sell its sturdy home and garden division to help ease the debt burden; it hopes to fetch at least $500 million but hasn't found a buyer.

With creditors knocking at its door earlier this year, Spectrum has had to scramble. It got temporary relief in March by refinancing much of its debt, a tool Spectrum and others may not be able to use in the near future since the junk-bond market froze up in late July. In all, the financing package cost $51 million, and interest rates run as high as 11.25%.

As a result, Spectrum's debt stands at $2.5 billion, roughly 9 times operating profits. That's not much different from where some of today's deals—such as the buyouts of ServiceMaster, Thomson Learning, and VWR International—are starting out. Spectrum "is too levered today based on poor operating performance," says THL's Sperling, who notes the loss in Spectrum is the exception in the buyout firm's history, which includes recent winners Warner Music Group Corp. (WMG) and the credit reporting business Experian Information Solutions. "It was not too leveraged at the time the deal was done."

Meanwhile, rating agencies are fretting. Based on its current rating, Moody's Investors Service (MCO) classifies Spectrum's debt load as "unmanageable." Standard & Poor's (MHP), which like BusinessWeek and Capital IQ is owned by The McGraw-Hill Companies (MHP), downgraded Spectrum to a CCC+ in February, a level at which one in four companies historically has defaulted within a year, based on the rating agency's statistics. Some analysts also suspect Spectrum may, in the end, look much like it did before it became a pawn in the private equity game. Says Deutsche Bank's Schmitz: "We wouldn't be surprised if, when the dust settles, we were back with the old Rayovac battery business."

By Elizabeth Woyke and David Henry


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