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Can leveraged buyout artists build firm foundations on soft money? Derek DeCloet investigates

Gerry Schwartz, Bay Street's master of the leveraged buyout, got it wrong.

A little more than two years ago, the Onex Corp. chairman stood in front of his shareholders and said he saw trouble on the horizon. Times were good. Banks were giving away loans easily. Companies were taking on oodles of new debt, and some wouldn't be able to handle it once the economy turned soft.

Onex would take advantage, setting up a fund to buy, at low prices, the debt of companies that were struggling or scraping by. "You can almost see what's coming," Mr. Schwartz said, "which is 18 months from now, distressed debt is going to be a big opportunity."

That was in May, 2005. Today, the project is on ice, according to sources close to Onex. Why? There simply aren't enough failing companies to invest in.

A strong economy became stronger, the trickle of easy money became a flood, and big bankruptcies have become non-existent. On balance, that's been good for the buyout industry (Onex included), which continues to astonish with its profligacy. Coming off a year in which more than $400-billion (U.S.) in American public firms were taken private, buyout firms are on pace to smashing all records this year, thanks to a string of mega-deals - TXU Corp., First Data Corp., Alltel Corp., Tribune Co. and, in all likelihood, BCE Inc., soon to be called Bell Canada, the country's 14th-largest public company. For the moment, there's no stopping private equity's "golden era," to borrow the phrase that Henry Kravis, the godfather of the LBO, used at a conference in Halifax a few weeks ago.

But behind the veneer of the self-congratulation, jaw-dropping riches and plain excess - witness Blackstone Group chief Steve Schwarzman, who made $400-million last year and hired Rod Stewart to perform at his 60th birthday party - the first cracks are beginning to appear. Some private equity players say too many deals are getting done at prices that are too high; on average, buyouts firms in the U.S. are paying roughly 50 per cent more for assets than they were in 2001.

The bidding wars are great for shareholders of public companies, but afterward, they also leave those businesses encumbered with far too much debt, much of it borrowed under looser terms than ever. Some of the biggest buyout deals of the past few years - Freescale Semiconductor in the U.S., Masonite International in Canada - are already showing some financial strain.

It's too alarmist to say that it's all going to come crashing to a tearful end tomorrow. But it's also foolish to believe that buyout activity, a major driver in the global bull market for stocks, can continue on its current path without eventually spawning some major business failures.

"Golden era," says a senior partner at one of Canada's largest private equity shops, who was in the room for Mr. Kravis's speech. "I didn't see it that way."

Adds Martin Fridson, who heads a Wall Street firm that does research on junk debt: "They may not say for public consumption that it's inevitable that there will be losses, because there's always some cock-and-bull story about why there won't be any defaults in leveraged buyouts. Every cycle, they come up with a new version of that. And it gets discredited every time."

But when the first mega-deal goes sour and lands in Chapter 11, who will feel the pain?

The bankers have played their usual role in fuelling the frenzy. This time, they've been joined by hedge funds, which have played a major - though hard to quantify - role in backstopping private equity deals. They may have the most at stake financially. But it's the private equity firms themselves who are taking the biggest risk with their reputations, gambling that their business model - which has worked so well on smaller deals - will be just as effective on monster ones.

The banks: Who needs 'em?

When it comes to private equity, the two most frightening words to any Wall Street banker are "burning bed," the nickname of a famous deal gone awry during the great LBO boom of the late 1980s. Investment bank First Boston lent hundreds of million of dollars to fund the buyout of the Ohio Mattress Co., and got stuck with it when the junk bond market when south and the mattress manufacturer was unable to refinance the loan. The episode led to First Boston's takeover by Credit Suisse Group.

Today, a few bankers have publicly voiced concern about foolish lending, among them Bank of America chief executive officer Ken Lewis, who recently got the attention of the world's banks when he said: "We are close to a time when we'll look back and say we did some stupid things."

That the banks will take some losses on LBOs is a certainty, but it's far from clear that they will suffer the most in this private equity cycle, because they've become far more efficient at getting rid of their debt quickly. In the U.S., banks hold just 20 per cent of "leveraged loans," a term that describes not just buyout loans but other junk debt, according the Standard & Poor's.

The other 80 per cent is held by institutional investors - hedge funds, mutual funds, pensions, insurance companies and so on. The biggest buyers are financial engineers who acquire a bunch of loans, pool them together as collateralized loan obligations, or CLOs, and sell them off in pieces - very often to those same hedge, mutual and pension funds.

CLOs didn't exist during the big buyout wave of the late 1980s, and they didn't become "dominant" buyers of high-risk loans until 2002 and 2003, says Steven Miller, who analyzes the speculative loan market for S&P. While they've been a haven for the banks as a place to easily offload speculative loans, the presence of CLOs creates a longer daisy chain - middlemen upon middlemen - dividing those loans up into ever-smaller slices.

The result is that the banks, now acting more as loan brokers, are less vigilant about the kinds of loans they arrange, since they know that they likely won't be holding the loan for long.

Does this sound familiar? It should - because it's similar to the way the U.S. subprime mortgage operated during its high-growth years. Mortgage brokers, scurrying to sign up clients as quickly as they could, were lax in weeding out customers with poor credit. When those borrowers began to default in large numbers, the usual buyers for subprime debt quit purchasing it, and those left holding billions in poor-quality loans - companies like New Century Financial - went broke, out of business, or swallowed their losses.

The fees for arranging loans are as alluring for the commercial banks as they were for subprime lenders.

"It's like crack cocaine for them," says the unnamed private equity partner. In LBO deals, "the banks don't care any more about the [quality of] credit. As long as they can sell it all, they're fine."

Large private equity firms know this and are taking advantage. The heated competition for their business means not only cheap money, but easy terms. So-called "covenant light" deals, such as Kohlberg Kravis Roberts & Co.'s $26-billion takeover of First Data, remove many of the usual conditions attached to loans; borrowers aren't required to keep their debt below 6 times their annual EBITDA, for example, or to ensure that their interest payments consume no more than half of their cash flow. (EBITDA is earnings before interest, taxes, depreciation and amortization.) The idea is to "make it harder for the banks to find a default that would allow them to call the loan," says Jay Swartz, a lawyer at Davies Ward Phillips & Vineberg LLP who works on private equity transactions. How many big LBOs are being done covenant light? When it comes to deals by KKR, Blackstone Group and other large private equity shops, "virtually all" are done this way now, confesses a New York-based banker for a large Canadian financial institution.

But it's not just bankers who are cutting the strings attached to loans. So are the junk bond investors who usually provide more permanent financing for leveraged buyouts. For instance: bondholders are typically offered "call protection," a guarantee from the company that they won't try to redeem the bonds for a certain number of years. A 10-year junk bond might have a guarantee for five years.

It gives the investor assurance that he won't lose his high-yielding piece of paper if interest rates take a dive. But borrowers have been whittling away the length of call protection or eliminating it altogether. Or they will water down other clauses that would protect bondholders if, for example, the company is flipped to another private equity firm.

Why do bond investors put up with this? "They don't really have much choice," says Mr. Fridson. "If you're managing a high-yield bond fund, there's really not an option of going to 25 per cent cash.

"So you have to invest in the best deals that you can find. And because there's so much money out there, the issuers can say, 'You want to argue about covenants? The deal's oversubscribed 3 to 1. See you on the next one.' "The hedge funds: The weakest link?

Low interest rates, friendly terms, high acquisition prices: that's the stuff of the 2007 private equity party. The hangover comes when the deals are done and the newly private companies are operating on a razor-thin margin of safety.

Three years ago, U.S. firms taken over in LBOs had free cash flow that equalled 2.6 times their interest expense - so if the business took a dive and cash flow fell by half, they could still make their payments. That's no longer the case.

The cash-flow coverage ratio has shrunk to 1.7 times, according the S&P's Mr. Miller, the lowest level since the bull market of the late 1990s.

These are the subprime borrowers of the corporate world, and they, too, have their own inventions for making a heavy debt load a little bit easier. The housing industry had adjustable-rate mortgages; Wall Street has "toggle bonds," which allow the borrower to choose to pay interest by issuing more bonds, paying even higher interest, instead of cash.

Toggle bonds are not a totally new concept, but they tend to be issued only in exuberant times. They have proven to be dangerous in an economic downturn. The best-known Canadian example might be CanWest Global Communications Corp., which sold a similar instrument called a pay-in-kind bond in 2000 to pay for its top-of-the-market acquisition of most of Hollinger International Inc.'s Canadian newspapers.

The advertising market was in recession soon after, and the pay-in-kind debt, which carried an interest rate of more than 12 per cent, was like a noose around CanWest's neck for years until it was refinanced.

But toggles are back in a big way in the LBO market, including in some of the biggest deals. Even once-staid pension funds are using them. OMERS Capital Partners, the private equity unit of Ontario's pension fund for municipal workers, joined with a U.S. firm to buy education assets from Thomson Corp. for $7.75-billion last month. The deal has yet to close, but the buyout group is already trying to raise more than $2-billion in high-yield debt -- almost all of it in toggle bonds.

It's easy to understand why a company would want to sell a toggle bond, but harder to reckon the appeal for those buying them. Who wants to lend money to a company that's so strapped for dough, it can't even pay its interest in cash?

Lots of people, it turns out. More than $5-billion of new toggles were sold through mid-May to help finance deals.

Anecdotally, most of the fingers point to the hedge funds as the most enthusiastic buyers of the highest-risk debt, although statistically it's hard to prove because they don't publicly disclose their investments.

Mr. Fridson says the reasons they do so are simple. Many hedge funds use borrowed money themselves to amplify returns. So all they need to do is find some debt that's yielding, say, 10 per cent, buy a lot of it with money they've borrowed at 7 or 8 per cent, and collect a healthy spread - and fat fees - in between.

And if that strategy explodes in their faces because they end up holding some worthless junk debt? So be it. For as long as it lasts, it's an easy route to profits. Hedge funds get into trouble and are forced to close shop all the time, but no one ever asks them to return their fees (generally 2 per cent plus 20 per cent of the investing profits).

"Why would you not just take the highest possible risk with other people's money? If there's literally no downside, it's the rational thing for you to do," says Mr. Fridson.

And that strategy has worked, just as subprime lending worked in 2004 and early 2005, because default rates on corporate debt are still close to zero, even on high-risk debt. The placid environment has made it much easier to sell debt that would be downright toxic in tougher times. A recent report by Edward Altman of New York University found that about half of all U.S. acquisitions last year were financed with debt that was the equivalent of "CCC" - the lowest credit rating applied to a solvent company. In 2003, only 11.5 per cent of deal debt was rated so lowly.

The history of such lowly debt like that is not very encouraging; usually, more than one-third of it goes into default within the first three years. It's not a question of whether a large LBO implodes, but when it will happen and who will be left holding the bag. David Rogers, who was a senior private equity deal maker at OMERS and now does consulting on private deals, has little doubt on the latter: "It's going to be one of these hedge funds." And who lends to the hedge funds? The banks.

The buyers: What, me worry?

In Halifax, Mr. Kravis tried to puncture the notion that today's private equity firms are gambling like never before. During the 1980s LBO craze, private equity firms like KKR would routinely buy companies and finance with less than 10 per cent equity, borrowing the rest. Today, it's more typical to see firms put in 30 per cent equity. But the flip side is that prices are a lot higher, so doing successful deals still requires loading up with debt. Private equity buyers are still able to acquire assets at 6 or 7 times EBITDA - BCE might sell for a little more than that - but those are becoming rarer. Bidding wars are pushing multiples into double-digits.

When BCE sold its Telesat unit last year to a private equity group, it surprised some observers by getting $3.25-billion (Canadian) - 11 times the satellite firm's EBITDA. Thomson's education assets went for an eye-popping multiple of 14 times, according to TD Newcrest, which had expected a purchase price in the $6.3-billion (U.S.) range (around 11 times).

It's a seller's market for companies, and just as private equity buyers are able to lean on their lenders, the sellers are able to lean on the buyers with some pressure tactics of their own. One is the use of "stapled financing," where the investment bank that's auctioning the business will simultaneously offer specific financing to the buyers - saying, for example, that they'll give the buyer a loan equal to 7 times the target's EBITDA. Stapled deals are not new, but they've become almost standard now on LBOs; the move has the subtle effect of establishing a minimum price for the deal.

Another tactic is to try to hurry along the due diligence. Brent Belzberg, founder of TorQuest Partners Inc. and a veteran of the private equity business in Canada, recalls: "We got a call from a U.S. fund that wanted to do a deal in Canada and said, 'We've done all the due diligence and we want half the equity from you.' " He likens it to buying a home without an inspection. "We just don't do it."

Easy money might be greasing the way, but are smart deals getting done? The unnamed private equity executive thinks buyout firms are asking for trouble by overpaying. At the very least, firms like KKR and Blackstone will find it hard to continue making 20-per-cent annual profits or better on their acquisitions. "I don't know how it can do anything but drive returns down," he says.

There are a lot of different views on what will bring this private equity cycle to an end. It could be a recession, or a serious move in junk bond yields, which haven't budged very far from their lows, despite higher interest rates in the U.S. and Canada. But most people agree a couple of high-profile disasters would sober up investors quickly, forcing them to demand sweeter terms for giving their money to the private equity firms.

One candidate for difficulty might be Freescale, taken out by Blackstone Group last year for $17-billion (U.S.). It's in a low-margin business, heavily reliant on one customer (Motorola) that is losing market share in wireless handsets. Moody's Investors Service just slapped a negative watch on the company because of a poor first quarter - its first as a private company. In Canada, investors squawked when KKR took over Masonite International, a door manufacturer, at what was perceived as a low price. But the public shareholders may have had the last laugh. Masonite's sales are falling and it recently lost a key contract with Home Depot.

Whatever brings the buyout bonanza to an end, it's unlikely to cause any serious shock to the banking system, which is in much better shape than it was when the 1980s LBO boom fizzled, says Martin Barnes, managing editor of the Bank Credit Analyst. It might do some harm to the equity markets, since it will deflate the illusion than any firm with cash flow is a plausible takeover target.

But the greatest damage might be suffered by the private equity firms themselves, who will, temporarily, lose some of the shine from their reputations as quintessential corporate fixers. The good ones like KKR and Onex will survive, even thrive, in the aftermath. For the rest, it's not going to be pretty.

© 2007 The Globe and Mail. All rights reserved.

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