Neil Unmack

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Bond investors won’t bail out private equity

August 5, 2009

Private equity and European high-yield bond investors have an awkward relationship. Investors recoiled from the market after telecom companies went bust in the dot-com crash. Issuance picked up during the recent credit boom, but PE firms raised most of their funding through private bank loans, many of which were repackaged into collateralised loan obligations (CLOs).

Now that banks won’t lend and the CLO machine is broken, financial sponsors need to find a way of refinancing the hundreds of billions of euros of loans that will come due over the next five years (S&P estimates over 500 by the end of 2015).

Just in the nick of time, investor interest in European high-yield bonds seems to be reviving. Investors are increasing their allocation to the sector, enticed by juicy returns as the market rallied after the credit market collapse last year. So far this year, high-yield issuers have managed to raise over eight billion euros, and bankers are hoping that companies who haven’t issued before will be able to come to market soon.

The great hope for PE firms is that this resurgence will allow them to refinance maturing debt, probably by issuing senior-ranking high-yield bonds to refinance a portion of senior bank debt, and extending the rest.
Certainly, the high-yield market will help, but PE firms and banks hoping to pass the buck by dumping overleveraged companies on the bond markets will have a hard time.

First, they will have to compete for a share of investors’ money with companies that are already well known: existing issuers and the growing number of fallen angels — companies that have slid below the investment grade band.

Then there is a more basic problem in that many PE deals simply have too much debt. At the moment, bond investors will buy BB-rated companies, and flirt with single-Bs, such as Virgin Media <VMED.O>, if they know the name well. But compared to these companies, the most recent batch of large PE deals such as EMI, which is tipped for a bond refinancing, doesn’t look very appealing.

Many LBO companies are terribly overleveraged after sponsors piled on debt to pay themselves a hefty dividend or as a result of secondary and tertiary buyouts, where PE firms sold companies to each other in a debt-fuelled game of musical chairs. The business plans drawn up at the time envisaged the companies reducing debt over the short term, but in many cases that hasn’t happened.

The latest data from Fitch Ratings is pretty disheartening. Some 12 percent of the more than 250 billion euros of debt issued by leveraged companies it rates is graded CCC. (If you’re wondering what that means, it includes companies with a combination of an “unsustainable debt structure”, “high liquidity risk” or a “broken business model” — not exactly the kind of proposition that appeals to bond investors.)

In all, over half of the entire crop of companies is rated B- or below, with leverage multiples of 6.7 times earnings before interest, tax, depreciation and amortisation — or higher. For many of these companies, the high-yield revival has come too late. It will help refinance problem companies, but only after a restructuring.

True, sponsors have some time to play with. Many PE firms were smart enough to extend their debt before the crisis struck, meaning the worst of the refinancing hump doesn’t kick in until 2013 and 2014. By then, if they are lucky, the high-yield market will have matured, investors will be happier with lower risk credits and banks will be lending more. The market may open up for companies that have managed to pay down some debt and proven some earnings stability through an economic downturn.

But others will still have too much debt. Sponsors will have to let them fail, break them up or restructure them by injecting more cash in exchange for a reduction in the debt load. High-yield investors will help with the refinancing, but banks and sponsors will have to take plenty of pain to lure them in.

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