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The cost of financing leveraged buyouts is falling, and in some cases creditors — which include banks — are letting them borrow more of the purchase price.
May 23 -
Past rallies in issuance of leveraged loans for mergers and acquisitions or leveraged buyouts have sputtered before, but macroeconomic factors are expected to keep investors bullish this time.
May 11
Is greed good after all?
Not so much for banks, when it comes to leveraged buyouts.
The oft-vilified strategy of investors loading up on debt to acquire a company is hot again, and a recent study of recoveries in defaults dating back to 1988 offers some vindication for it. But bank debt was the big exception.
Moody's Investors Service found that investors fared virtually the same in 200 defaults by companies owned by private equity firms as they did in 800 defaults by companies not involved in leveraged buyouts.
Yet the credit banks extend to PE firms recovered at a lower rate in LBOs than loans in non-LBOs. The rate would have been even lower if not for the fact that LBO companies were more likely to default through distressed exchanges, which Moody's considers to be defaults and which normally allow for 100% recovery by lenders.
The Moody's study found that the average recovery rate for all debt issued to fund LBO deals, including loans and various kinds of bonds, was 54%, nearly the same as the 55% recovery rate for the non-LBOs.
Senior secured bondholders also fared similarly in defaults of LBO and non-LBO companies, recovering roughly 66% of their investment in both cases. Moving down the capital structure, there were notable differences in recovery rates, with senior unsecured bondholders recovering 41% in non-LBO deals and a 37% in LBO deals, while subordinated bondholders recovered 30% in non-LBO deals and 24% in LBO deals.
The differential for bank debt, which ranks highest in the capital structure, was bigger. Lenders in LBOs had a 75% recovery rate, compared with more than 83% in non-LBOs. And Moody's said that, had it not been for distressed exchanges, in which investors agree to swap debt for new securities with a lower value, lower interest rate, or longer maturity, bank debt recovery rates in LBOs would have been even lower.
LBO companies are also more likely to default through prepackaged bankruptcies, which tend to produce higher recoveries than regular bankruptcies or liquidations, than non-LBOs, according to the Moody's study. Less than half, or 47%, of the LBO defaults were regular bankruptcies, compared with about two-thirds, or 63%, of non-LBOs. Prepackaged bankruptcies accounted for 35% of LBO defaults and 20% of non-LBO defaults.
Despite all of these caveats, some practitioners said the study should serve to correct some misconceptions about LBO financing.
"Ironically the more flexible the bank debt covenants are, the easier it is to do distressed exchanges and buy time," said Richard Farley, a partner at law firm Paul Hastings who focuses on buyout deal financing. "You do better as a bondholder when the senior lenders don't pull the plug right away."
The report justifies the preferred terms that buyout firms get on deals, he said. "Perhaps underlying all of this is the notion that having a sponsor there who can orchestrate a process as an equity holder, cajoler and knowledgeable market participant can drive better outcomes than when you don't have that constituency in the process, which is why sponsors sometimes get better terms," he said. "This seems to validate that."
The attorney compared the LBO default study to a June 2011 report Moody's published showing that defaults by issuers of covenant-lite loans were below the historical rate. "A lot of first-blush conventional wisdom on these things doesn't always pan out," he said.
One of the reasons for the lower recovery of bank debt in the 200 LBO defaults was a smaller "cushion" of subordinated debt in these deals, Moody's said. The average cushion for bank debt in the LBOs was 44.99%, compared with 50.46% for non-LBOs. Subordinated debt absorbs losses before the banks do.
That smaller cushion may help motivate distressed exchanges. "Although [private equity] sponsors have strategic incentives for distressed exchanges, they may also pursue an early default via distressed exchange … in order to leave the bank debt untouched in default," it said. "LBO sponsors need to preserve relationships with banks in order to maintain access to future deal funding."
The LBO revival has been strong, though the turbulent markets of late could put it at risk.
As of June 6, there were 11 bonds totaling $8.85 billion issued for LBO deals this year. That is out of a total of 655 LBO deals with a volume of more than $62 billion, according to Dealogic.
By comparison, there was $19.7 billion issued via 34 deals to back buyouts for all of 2011. That was the most since 2007's record of more than $50 billion across 52 deals.
However, U.S. LBO loan volume was at $10.3 billion as of June 6, down 54% from $22.2 billion for the same period of 2011 and the lowest year-to-date figure since the $1.1 billion at this point in 2009.
LBO loan pricing is also the highest on record, according to Dealogic, with the average loan marketed in the U.S. for an LBO reaching 517 basis points, wider than the previous record of 516 basis points in 2009 and 68 bps higher than the 2011 year-to-date average margin of 449 basis points.
So far this year, only four out of 32 defaults, or 12.5%, were distressed exchanges, according to research S&P published last month. Of those four — Barneys New York, Mohegan Tribal Gaming Authority, Verso Paper and Yell Group — the only LBO is Barneys.
