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Private Equity's White-Knuckle Deal


By Emily Thornton COVER STORY PODCAST

What does a buyout baron do when the business climate changes dramatically between the announcement of a major deal and the closing? It's a question that has given many of the world's most successful private equity firms, and the big investment banks that lend them the money, insomnia in recent weeks. In late August came the answer when a deal that had been on the verge of death was saved at the last minute. The twists and turns in the negotiations shed light on how more than $300 billion worth of pending buyouts can be salvaged—and offered a glimpse into what the future holds for the $1 trillion private equity industry.

The biggest dealmaking bonanza in history was still raging in June when three firms, Bain Capital, Carlyle Group, and Clayton, Dubilier & Rice, bid $10.3 billion to buy Home Depot Inc.'s HD Supply business, a collection of small suppliers of construction products. Three banks, Lehman Brothers (LEH), JPMorgan Chase (JPM), and Merrill Lynch (MER), agreed to provide the buyers with a $4 billion loan. Banks lend private equity firms money with the aim of selling the loans to investors and collecting fees from both groups.

But in July conditions changed—quickly. The subprime mortgage mess suddenly spread to the broader debt markets as investors who had been buying up exotic loans and bonds quit cold turkey and rushed to the safety of Treasury bonds. The crunch posed particular risks for leveraged buyouts because banks and private equity firms had come to rely on loans and bonds with extraordinarily loose repayment terms to fund their deals.

Few felt the pressure as much as Donald J. Gogel, Clayton Dubilier's 58-year-old CEO. Just before Home Depot's 11 a.m. board meeting on Sunday, Aug. 26, to vote on the deal, Lehman Brothers Inc. CEO Richard S. Fuld and JPMorgan Chase & Co. Vice-Chairman James B. Lee Jr. were trying to tighten the terms of the loans and bonds to which they had previously agreed. The banks, buffeted by the credit markets, wanted more financial protection. Gogel and his partners had been flexible on the price of the deal, the amount of cash they would put in, and other variables. But on the loan they wouldn't budge: They wanted the original terms or the deal was off.

After several more hours of furious bargaining, an accord was reached. The banks agreed to provide financing, including a reduced loan of $1 billion. Home Depot agreed to assume the loan payments if the firms were to default on it. And the buyout firms agreed to put more cash into the deal, pay the banks higher fees, and give Home Depot a 12.5% equity stake in HD Supply. The final price tag came to $8.5 billion.

The debt terms were revealing. BusinessWeek has learned that the package includes two loose types of funding that have flourished in recent years—exactly the kinds of loans and bonds that pundits had assumed were dead. The $1 billion loan was of a type called "covenant-lite," named for its easy repayment terms. And the deal included $1.3 billion in "payment-in-kind" bonds, which allow the borrowers to pay off the debt with securities instead of cash.

Hanging in the balance on that scorching August day was more than one buyout. All of Wall Street was looking for clues on how the remainder of the year—and beyond—might play out. Had the HD Supply deal fallen through, it would have sent shock waves. Its success shows that other deals already in the works can be rescued as long as the parties come to the negotiating table prepared to make major concessions.

At the same time, the banks' nervousness shows that the days of covenant-lite loans and other such exotica are numbered. When new deals start filling up the pipeline, they'll look much different from the ones there now. Bankers say they stand to lose up to $50 billion on loans and bonds they've already pledged if they can't unload them to investors. The biggest commitment still looming over their heads, according to market tracker Covenant Review, is the staggering $48.8 billion in financing for Madison Dearborn Partners and two other firms to buy the parent of Bell Canada, BCE Inc. (BCE) Kohlberg Kravis Roberts & Co., meanwhile, is counting on $14 billion in loans to purchase credit-card processor First Data Corp. (FDC) and $26 billion in loans to buy utility TXU Corp. (TXU) with partner TPG Capital.

A retreat from loans with easy terms could put a damper on private equity dealmaking. Covenant-lite loans burst on the scene a few years ago and quickly gained favor among buyout firms looking for easy money. Traditional loans carry strict requirements that dictate when the borrowers have to repay them. Some stipulate that the borrower's profitability must improve every year; if it doesn't, the lender has the right to renegotiate the loan at a higher interest rate or demand repayment immediately. Covenant-lite loans, by contrast, come with relatively few stipulations. Payment-in-kind bonds are just as loose, allowing borrowers to pay off the debt by issuing more securities. Such freewheeling terms are advantageous for borrowers but risky for the people holding the debt.

Investors threw caution to the winds until the credit crunch began, and the market for risky securities vanished overnight. The $8.3 billion in covenant-lite loans made in June shriveled to zero in August, according to Standard & Poor's Leveraged Commentary & Data (MHP).

Gogel, however, was intent on preserving the easy financing for the HD Supply deal. Traditional loans like the ones the banks were now demanding had wreaked havoc on private equity firms earlier this decade when the economy slowed and companies had trouble meeting their loan covenants. Clayton was bruised more than most. Gogel was determined not to repeat that painful history.

Clayton's founders had built a firm around a business strategy that more or less has become the blueprint for the modern buyout shop. Before, private equity focused mostly on financial engineering: improving companies' fiscal health using various balance-sheet tricks. Clayton, formed in 1978, was among the first to obsess over operations as well, hiring top industrial managers to run its companies. "In many ways, the rest of the industry has followed in their footsteps," says Michael Klein, chairman and co-CEO of Citi Markets & Banking at Citigroup (C), which invests in Clayton funds. In 1993, BusinessWeek dubbed the firm's partners "Lords of Leverage." Harvard Business Review cited Clayton as an example of how leveraged buyouts "increase value through better governance." Co-Founder, Chairman, and name partner Joseph L. Rice III was featured as one of America's greatest dealmakers in a 1999 book called Masters of the Universe.

But Clayton was unprepared for the financial storm about to batter the industry. When the economy slowed from 2000 to 2002, loans carrying strict terms helped push three companies Clayton controlled into bankruptcy and render another worthless.

HD Supply bears eerie similarities to U.S. Office Products Co., a rollup of office-supply companies bought by Clayton in 1998 that went bankrupt in 2001, undone not only by onerous debt but also by poor management. And Clayton has almost as much riding on HD Supply as it did on U.S. Office. HD Supply accounts for 15% of Clayton's most recent buyout portfolio, one of its biggest stakes since the 21% chunk once allocated to U.S. Office.

U.S. Office and the other losses cast a pall over Clayton that lingers to this day. Nearly a third of the value of its two biggest buyout funds was wiped out, prompting a rethink of every aspect of its internal operations. The debacle made it difficult for Clayton to raise money during the biggest fund-raising frenzy the industry has ever seen. While seven other firms each raised more than $10 billion for their latest funds, including the staggering $21.7 billion collected by Blackstone Group (BX), it took Clayton almost two years to pull together its most recent $4 billion fund. Clayton had been the seventh-largest private equity firm during the 1990s, according to Thomson Financial (TOC); now it's ranked a lowly 38th.

Gogel's stubborn stance in the HD Supply negotiations stemmed from the lessons he learned during those difficult years. In hindsight the firm had juggled too many projects at once, often rushing into buyouts without performing sufficient due diligence. It also dove headlong into industries it had never navigated before. Onerous debt loads exposed those problems and made them worse.

Clayton's experience is a sign that if firms try to make aggressive deals in 2008 by relying on traditional loans and bonds, the fallout could be painful. The seeds have already been sown for disappointing private equity returns. The biggest firms today are managing about twice as many deals as they did five years ago—and those deals are far larger and more complicated than the earlier ones. According to M&A tracker Dealogic, KKR announced five buyouts in 2002 worth an average of $1.8 billion. This year it has announced 11 transactions valued at $11 billion each. TPG Capital unveiled five buyouts in 2002 worth $770 million on average, vs. nine this year valued at $9.7 billion each.

The acquisition targets have gotten quite exotic, too. Blackstone raised eyebrows last year when it bought one of the world's largest chipmakers, Freescale Semiconductor Inc. (FSL), for $16 billion, a blockbuster transaction in an industry few private equity firms have dared to enter. In 2005, Cerberus Capital Management acquired a plasma protein therapy producer called Talecris Biotherapeutics Inc., and in June of this year, Oak Hill Capital Partners bought commercial aerospace parts suppliers like Primus International—both initial forays into those industries. Says Oak Hill Managing Partner Denis J. Nayden: "We think there's a great opportunity here, and there will be a lot of growth."

Private equity firms have already embraced debt to a seemingly dangerous degree. On average they're paying 14.7 times the target companies' operating earnings, up from 3.8 in 2002, estimates Thomson Financial. Many industry veterans think the easy terms of their existing debt will keep them out of trouble. Others doubt it. "In the end, the high levels of debt will come back to haunt companies," warns Christina Padgett, senior vice-president at Moody's Investors Service (MCO). Even top financiers are starting to suggest that firms are sailing into danger. "Given high leverage levels, it is inevitable that deals will get into trouble when the debt has to start being paid off," says Robert A. Kindler, vice-chairman of investment banking at Morgan Stanley (MS).

The $10.3 billion bid for HD Supply was just the 10th-biggest of 2007 in terms of size, but by late July it had become one of the year's most important. Home Depot's new CEO, Francis S. Blake, had been talking about selling the unit since February and was planning to use the cash for a $22.5 billion stock buyback. But the deal got caught up in the credit crunch. Hedge funds were blowing up, the stock market was whipsawing, and even the most experienced professional investors were stepping to the sidelines. At different points during the negotiations, there were concerns that parties would drop out as the priorities of firms and individual dealmakers clashed.

At the beginning of the credit crunch, people familiar with the deal say, bankers warned the buyout firms that they needed to persuade Home Depot to cut the price and change the financing terms or the banks wouldn't provide funding. Members of the three buyout firms met with Blake at Clayton's Park Avenue headquarters. To the buyout firms' relief, Blake agreed to cut HD Supply's price to around $9 billion and keep a 12.5% stake in it. He also agreed that Home Depot would guarantee a $2 billion covenant-lite loan for the buyers. The lower deal price certainly appealed to the buyout firms. The discussions were "all remarkably free of acrimony," says someone close to the deal.

But while the proposed bank funding had shriveled from the original $4 billion, bankers were still nervous about unloading a $2 billion covenant-lite loan. Says someone close to the deal: "The banks said: Home Depot gets to sell its business, [the buyout firms] get a transaction that works, and we get losses. How is that fair?'" At least one banker floated the idea of shelling out for the buyout firms' $300 million breakup fee if they scuttled the deal, a levy the target company usually receives.

Some members of the Home Depot board were incensed that the banks were balking at the revised terms. On Aug. 9, in a move seemingly designed to reassure shareholders that the transaction would happen and to pressure the banks, Home Depot issued a news release saying that it had entered discussions with Clayton, Bain, and Carlyle to restructure the June agreement.

Senior members from each of the buyout shops then holed up in the office of Clayton's legal counsel, Debevoise & Plimpton, to sketch out possible scenarios. Over the next several days, they came up with more than a dozen plans.

The banks, too, were working on new pitches. On Aug. 23 bankers shocked the parties with a new proposal: no bank loan, large bond guarantees, higher fees, higher interest rates, and a stipulation that the buyout firms would buy part of the debt from the banks. So incensed was Home Depot that it threatened to issue another release saying the deal was off and that it would litigate to the fullest possible extent, according to people familiar with the negotiations.

Carlyle's team resolved not to go forward with the deal unless something resembling the earlier proposals, including loans, could be worked out. Merrill Lynch & Co. said it was concerned about proceeding without one of the buyers. The banks asked for more time.

Gogel took the lead among the private equity CEOs in the late-hour bargaining. "He was the linchpin of the negotiations," says JPMorgan's Lee. Clayton had unusually strong ties to Home Depot. In 2001, Clayton brought in former General Electric Co. (GE)CEO Jack Welch as a special partner, part of the turnaround strategy prompted by its investment losses. Home Depot's co-founder and board member, Kenneth G. Langone, is a former GE director. HD Supply's chief, Joseph J. DeAngelo, is a GE alum. And DeAngelo was hired by Home Depot's former CEO, Robert L. Nardelli, another GE veteran.

By Sunday morning, Aug. 26, the parties were bleary-eyed from a string of all-nighters and desperate to strike a deal. Gogel, Fuld, and Lee hammered out the broad outlines of an agreement that had the buyout firms paying more in fees and putting in more equity, and Home Depot agreeing to bigger fees and the 12.5% stake in HD Supply. The banks agreed to a $1 billion covenant-lite loan guaranteed by Home Depot as well as $1.3 billion in payment-in-kind bonds.

Gogel called Home Depot board member Langone to tell him the group needed just a little more time to tie up the loose ends. Home Depot was losing patience. "We're tired of this charade," Langone told Gogel, according to someone familiar with the conversation. "The board is fed up. Enough is enough. Today is the day we pull the plug. There has been nothing but bad faith [on the part of the banks] all around on this deal. The board is at a point where we don't want to go any further." Gogel pleaded for one more chance. The board reluctantly extended the 11 a.m. deadline by six hours on the condition that Gogel promise "no bluffs." With many small details still in doubt, Gogel boarded a plane to travel to a friend's wedding in Virginia. Over the next several hours, talks continued, pulling Gogel out of the wedding chapel to field phone calls. At 4:45 p.m., the final deal was struck.

Home Depot had succeeded in raising the cash needed for its share buyback. The banks had managed to turn a $4 billion albatross into a much smaller one. And the buyout firms won what, to them, was the most important battle in the war. They had been flexible on the size of the deal, the amount of equity they would put in, the fees they would pay the banks, and other important factors. They simply wouldn't take on tough loans, even small ones.

Now comes the hard work of making the buyout succeed. The private equity firms have ambitious plans: They want to increase HD Supply's offshore sourcing, restructure its warehouse system, and boost its private-label business—all amid a housing downturn. As insurance against a worse-than-expected bust, the firms took out a revolving credit line in excess of $1 billion.

Gogel stresses that HD Supply is in far better shape than U.S. Office Products was when Clayton bought it. He says the companies Nardelli rolled up are of a much higher quality. And he points out that Clayton did due diligence on one of them, Hughes Supply Inc., for a full year, only to be outgunned by Nardelli's $3.47 billion bid in 2006.

Clayton and its partners dodged a bullet on HD Supply, securing extraordinary financing terms on a transaction that others had assumed was doomed. But banks won't be so accommodating in the future. And that is going to pose a challenge to the private equity business model, as firms balance their hunger to do deals against the greater risks that they will face when they borrow. Clayton Dubilier, chastened by its recent history, seems poised to err on the side of caution. "We are willing to accept more operating risk than other firms," says Gogel, "but only if we can [take] less financial risk."

Join a debate about the tax breaks on private equity gains.

Thornton is an associate editor for BusinessWeek


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