Credit Market Sea Change?

The Bear Stearns internal rescue was a wake-up call, for the credit markets. Several junk bond offerings fell through, or were withdrawn, in the past few days. Is this a sea change, in the credit markets? Will lenders finally begin to price in risk?

http://online.wsj.com/article/SB118299592168350999.html?mod=home_whats_news_us

Market's Jitters Stir Some Fears For Buyout Boom
Takeover-Related Debt Gets Chilly Reception; Hearing 'Wake-Up Call'
By SERENA NG, TOM LAURICELLA and MICHAEL ANEIRO
Wall Street Journal, June 28, 2007; Page A1

...Much of the recent record wave of takeovers has been built on borrowed money, fueled by easy credit terms and low interest rates. But on Tuesday, investors rejected...[article then lists rejected or withdrawn junk bond offerings. -- W]

..."The biggest risk we face -- and there are a lot of things that contribute to this risk -- would be a very big crisis in the credit markets," ... A "sentiment shift," he said, "could unravel very quickly" the vast wealth that has been created by the takeover boom.

Treasury Secretary Henry Paulson called the market jitters "a wake-up call to focus on excesses" that have developed in recent years in the debt markets. [Glad to see he's waking up...long past due. -- W]

Several factors underlie the new pushback against buyout financings. One is the growing awareness that investors have been demanding very little in return for the risk they have accumulated in snapping up buyout-related loans and debt.

Yields on junk bonds, when compared with ultrasafe U.S. Treasury securities, hit historic lows around a month ago. [This might be a good time to short junk bond ETFs, if you're into that kind of thing. A historic low in risk premiums, followed by a developing crisis. -- W]

In addition to demanding higher interest rates, investors are resisting many bonds and loans whose terms they believe to be too easy on borrowers. Investors have rejected a number of recent deals that included "payment-in-kind" provisions, which allow companies to postpone debt payments to their lenders if they run short of cash. Investors also have rejected loans that are light on certain common performance requirements, known as covenants. [About time! They were nuts to allow these, in the first place! -- W]

"A lot of managers are starting to get miffed about deals with no covenants and the fact that underwriters seem to have little regard for the risks investors are assuming..." [Miffed?! We are talking hundreds of millions of dollars. Next thing you know, they'll be having hissy fits. ;-) -- W]

Banks in several cases have been stuck holding portions of loans or bonds they planned to parcel out to investors, something that could make them more selective in underwriting deals. [The banks are being paid to lend responsibly. That's their job. It's a disgrace that they let underwriting standards slip, since they were passing the risk to investors. --W] Meanwhile, companies and their private-equity buyers face bigger drains on their cash flow as their interest costs rise.[end quote]

It's about time that lenders demand responsible lending (no "toggle" or "covenant lite" garbage). It's about time that borrowers pay a reasonable risk premium, and face up to paying their obligations...or stop trying to borrow money they can't afford to pay back.

The practical consequence may well be a sea change, in the credit markets. Leveraged takeovers will become fewer and more expensive. The last peaks of leveraged buyouts (value of stock plus debt assumed) were 1988 ($100B -- remember the movie "Wall Street"?) and 2000 (about $30B). In 2006, buyouts totaled $400B. This year, up to today, is already up to $300B.

What I don't understand is...how does the buyout activity affect the stock market, as a whole?
Wendy

Hi wendy,

maybe this helps.

Where Was The Merger Monday..... ?

This could be a coincidence but i think that we really have seen the peak in merger activity. When i talk about the peak i mean in terms of the cash component. It could well be that some gigantic stock deals will pump up the total amount. But this should have not such a big impact on equities overall. The key point is that with a lower cash component fewer fresh money is flowing from credit markets back in the equity markets. And i think one should remember that the actual deals that are and will be announced soon were done when credit conditions were almost perfect. Even when this "call" is premature the buyout premiums should shrink.

Das ganze könnte natürlich auf reiner Zufall sein, aber ich denke das wir in der Tat den Höhepunkt der Fusionsaktivitäten gesehen haben. Damit meine ich den Teil der Fusionen die mit Cash abgewickelt werden. Es kann sehr gut sein das noch weitaus gigantischere Aktiendeals durchgehen und die Gesamtzahl nach oben hieven. Entscheidend aber wird sein das hier zukünftig deutlich weniger frisches Geld vom Kreditmarkt and den Aktienmarkt zurückfließt, es also mehr oder minder ein Nullsummenspiel ist. Zudem sollte man bedenken das die ganzen Deals die jetzt oder in den nächsten Wochen bekanntgegeben werden noch zu Zeiten angeleiert worden sind als das Kreditmarktumfeld perfekt gewesen ist. Selbst wenn sich die these als voreilig erweisen wollte so dürften doch in jedem Fall die Aufschläge bei den (Cash)Übernahmen deutlich leiden.

The buyout boom may be about to hit a bump.

After years of supersize private equity deals, investors in the debt that supports these transactions — the lifeblood of the industry — have begun to not so quietly push back at several prominent transactions.

Rising interest rates and tougher terms from investors may signal that private equity players will soon be struggling to continue reaping the outsize returns that have made the buyout business so lucrative.

Already a raft of bond offerings for recently announced deals, including the $7.75 billion buyout of Thomson Learning and the $7.1 billion deal for U.S. Foodservice, have been scaled back after facing resistance from investors.

This week, two other buyouts, the $4.7 billion deal for ServiceMaster and the $6.9 billion sale of Dollar General, are expected to price their bonds, and they may serve as an important barometer for a series of even larger deals to sell bonds to investors this summer.....
These setbacks come as Cerberus Capital Management begins a road show this week to sell bonds for its $7.4 billion buyout of Chrysler; it plans to raise up to $62 billion. First Data, which was acquired by Kohlberg Kravis Roberts for $29 billion, plans to price its bonds next month. And later this year, bonds for the buyout of TXU, the largest in history, will go on sale. TXU is likely to seek about $24 billion.

The resistance from bondholders may already be cooling the buyout market. The proverbial Merger Monday has not been so merger-filled lately. Yesterday, only seven deals were announced, compared with 43 a week ago and 84 on June 4, according to data from Thomson Financial.
“In the last couple of days, we’ve seen some cracks,” said Kingman Penniman, president of KDP Investment Advisors, a bond research firm. “Private equity people have for a long time now gotten funding at very low rates and very liberal terms. The market has known for a long time that this was ridiculous.”

Not only bondholders but banks themselves appear to be thinking twice before they agree to lenient financing of these huge deals.

A small correction appeared to have taken place Friday when Thomson Learning scaled back the debt offering it hoped to sell to finance its buyout by two private equity firms, Apax Partners of Britain and the buyout arm of the Ontario employees’ pension fund. Originally, Thomson, a former division of the media publisher Thomson, sought $2.14 billion; it is now seeking $1.6 billion.

“There’s not a lot of room for error in these transactions, so investors have become very cautious,” said Chris Donnelly, who tracks leveraged finance at Standard & Poor’s Leveraged Commentary and Data. “Investors have been pushed to the wall on structure. At this point, we can’t go any further.”
> European data q1 2007

Among the changes Thomson made was to eliminate a $540 million provision for a pay-in-kind toggle, a type of debt that allows interest to be paid in cash or with the issuing of more bonds. The entire offering must now be paid back in cash, and Thomson Learning agreed to add more covenants to both the loan and the bond portion of the sale.

U.S. Foodservice, a division of Royal Ahold of the Netherlands, has now twice scaled back its own debt offering to help finance its buyout by Kohlberg Kravis and Clayton Dubilier & Rice. Scheduled to go on sale today, U.S. Foodservice’s offering will now also be paid back in cash, not with the issuing of more bonds.

thanks to http://bespokeinvest.typepad.com/bespoke/

Pay-in-kind debt, in particular, has fueled the buyout boom, largely because of the flexibility it affords private equity firms to pile on debt. Those instruments, proponents argue, allow companies to avoid bankruptcy.

But, according to Mr. Penniman, that debt has also loaded up many companies with potentially more debt than they can pay off.

Companies just cannot keep issuing debt, he said. “That assumes the market is pretty stupid.”

> As seen in subprime.........

Cracks in Credit

http://www.bloomberg.com/apps/news?pid=20601039&sid=apz1wFyR5x3Q&refer=home

Cracks are starting to appear in the credit market, threatening to disrupt the flow of easy money that has fueled a record pace of leveraged buyouts. No wonder Blackstone Group LP is trading below last week's initial public offering price.

ServiceMaster Co., which owns pest-control and gardening companies, is the quarry in a $5.2 billion buyout by Clayton Dubilier & Rice Inc. The company failed to find buyers for $1.15 billion of a bond flavor called pay-in-kind toggle notes this week, intended to fund the takeover.

Instead, Downers Grove, Illinois-based ServiceMaster will split the sale between ordinary debt and toggle notes, which give it the right to hand investors more debt instead of interest payments.

US Foodservice, a unit of Royal Ahold NV, the Dutch supermarket chain being bought by Clayton Dubilier and Kohlberg Kravis Roberts & Co., took three stabs at sweetening the terms of its planned $1.55 billion fund raising before junking the deal. Toggle notes again proved unpalatable to investors.

Also this week, KKR boosted the interest payable on a $2.43 billion loan funding its purchase of discount retailer Dollar General Corp., investors who may buy the debt told Bloomberg reporter Harris Rubinroit. Instead of as little as 2.5 percentage points more than money-market rates, the loan will pay a premium of 3 percentage points, boosting the potential quarterly interest payment to as high as 8.36 percent.

And Thomson Learning, a unit of Thomson Corp., scrapped the riskiest slice of a planned $2.14 billion bond sale last week. It boosted the interest it was willing to pay on its loans and cut the amount of debt offered to $1.6 billion to get the sale away.

via Russ Winter http://wallstreetexaminer.com/blogs/winter/?p=864#comments

Catalyst Paper Corp., citing “adverse” market conditions, scrapped a $200 million offering of junk bonds the Canadian company planned to use for funding its business and other investments or acquisitions.

- Underwriters delayed the launch of a buyout-financing deal for Myers Industries Inc. in the hope that the market would settle down in coming days. Late in the day, Magnum Coal Co. became the latest company to postpone a junk-bond offering, this one for $350 million.

- In Europe, Arcelor Finance, the borrowing vehicle for Arcelor SA, which is being acquired by Mittal Steel Co., put off its plans to issue more than $1.34 billion in bonds, citing the turbulent debt market. In Malaysia, shipping company MISC Bhd. put plans for a $750 million bond offering on the back burner.

- MISC, the world’s biggest owner of liquefied gas tankers, day shelved its $750m bond offering.

- June 28 (Bloomberg) — Carlyle Group, the buyout firm run by David Rubenstein, postponed a planned $415 million initial public offering of a fund that invests in bonds backed by mortgages after a slump in the U.S. subprime market.

KrisB

June 28 (Bloomberg) – Kia Motors Corp., South Korea’s second-largest automaker, canceled plans for a $500 million bond sale this week, joining at least seven companies abandoning borrowing as investors cut demand for riskier assets.”

Whether this is the sea change or not, it seems clear to me that all of this is way, way too late.  The inflation has done its work now. Prices have been distorted in bizarre ways all across the economy -- turning just about everybody into financial speculators and transfering countless billions of dollars from ordinary folks to the vultures in the banking industry and on Wall Street. The parallels with previous manias are there for all to see, but it seems relatively few have their eyes open to that insight.

It's too late now for responsible behavior to have a significantly beneficial impact on the outcome. Better sooner than later, for sure, but the damage has been done. If only the government, and the Fed, would now get out of the way and let relatively free markets sort out this mess. If our economy's price structure were allowed to reflect demand based on actual income, instead of rapidly rising debt and money creation, we would see people and economic resources reallocated to their best uses within a few years. It would be painful for many people, but it will be even worse with the Fed and the government attempting to manage the economy and control prices. And, of course, we should really say governments (plural), because we are likely to see a period with global or at least international dislocations that must be sorted out before the global economy is again ready for healthy growth.

Tom

My husband reported an NPR broadcast a few weeks ago here Allan Sloan stated  that when Private Equity  cease to function we will see a downturn in the market.  PE depends upon cheap credit.  I think Wendy's called it!  It may take a while for it to permeate the system, however.

"... when Private Equity  cease to function we will see a downturn in the market.  PE depends upon cheap credit. "

Absolutely right on, IMO. I don't know if that will mark the beginning of a market downturn, but it will certainly mark a major change in the credit dynamics -- and the credit expansion appears to be driving absolutely everything in the economy right now.

Doug Noland's piece this weekend (http://www.prudentbear.com/articles/show/2053) does a good job of getting into the credit bubble dynamics and the possible meaning of recent developments. I have posted, below, a couple of his paragraphs. (Anyone not familiar with Noland's work: be sure to skim through the many pages of news excerpts to his personal analysis at the end.)

Tom

<start quote> Subprime imploded specifically because of “Ponzi Finance” dynamics.  As long as Credit was readily available, individuals could borrow and/or refinance to a more accommodating mortgage.  But the day the music stops is the day Credit losses begin to explode.  And when it comes to runaway Credit booms, subprime was no anomaly.  The perpetuation of the subprime boom was the (only) means for an overheated Credit system to finance the marginal borrower - in order to sustain the housing/mortgage finance Bubbles.  Enormous festering risks were well-concealed by the illusion of perpetually rising asset prices and limitless market liquidity.

 

I won’t attempt to make the case that the global M&A Bubble is (quite) as acutely vulnerable to “Ponzi” dynamics as subprime.  But we do know that a proliferation of deals has created a current pipeline of hundreds of billions of risky corporate loans that will need to be sold into an increasingly risk-challenged marketplace.  Additionally, the M&A boom has been instrumental in inflating global equities markets, both by bidding up prices and fostering general liquidity and speculative excess.  A reversal of these dynamics is now a distinct possibility.  A serious market liquidity problem will commence with any move by the leveraged speculators to aggressively hedge risk and/or place bearish bets. <end quote>

The $Trillion reset in ARMs over the next six months will roil the foreclosures and delinquencies. Since it can take six more months for the banks to actually take possession and then start to sell the homes, that pushes the day of diaster to about a year from now.

Why diaster, because by a year from now the rating agencies will be forced to declare the CDOs as junk. That’s Trillions in leveraged and borrowed funds collaterialized, squared and synthetic complex financial instruments marked down to 50% or less.

Don't forget that private equity is now a political issue. Certainly in the UK, Ireland and all over mainland Europe, unions are beating drums about how private equity leads to job losses. Given the cosy relationships generally enjoyed between banks and governments, a relationship they won't be keen to disturb, this may further dissuade them from financing LBOs.

When banks held a mortage, as is still the case here in Australia, it was in their own interest to adjust the rate charged for the loan. In fact it was common to note how quickly the banks reacted to a rise in official interest rates, compared to the slow way they dropped in response to an interest rate decrease!  The point I am making is that the charges directly affected their business. Will this now change in the USA now that these debts have been cut up and have many owners, owners who do not have a direct say in the administration of the loan ? Will interest rates automatically change with the change in official interest rates? Will the "ARM"s automatically reset at the appropriate rate? And even if the answer is "theoretically yes", will the practice match the theory? I don't know of the administrative procedures governing these practices but can imagine that obfuscation would be easy and, in the present financial climate, would advantage those who wish to maintain the rosiest picture possible of the mortage market.

LBO Debt Proves Hazardous for Fidelity, Lehman, TIAA-CREF Funds

http://www.bloomberg.com/apps/news?pid=20601109&sid=aKzJqs78jqaY&refer=home

July 5 (Bloomberg) -- The world's biggest bondholders have had their fill of leveraged buyouts, convinced that increasing mortgage delinquencies will drag down the U.S. economy and drive debt-laden companies into default.

TIAA-CREF, which oversees $414 billion in retirement funds for teachers and college professors, is boycotting some debt offerings used to finance LBOs. Fidelity International, a unit of the world's largest mutual fund company, and Lehman Brothers Asset Management LLC, the money-management arm of the third- biggest bond underwriter, say they're avoiding debt from buyouts.

Investors are getting skittish just as private-equity firms led by Kohlberg Kravis Roberts & Co. and Blackstone Group Inc. prepare to sell $300 billion of bonds and loans to finance LBOs, according to Bear Stearns Cos. In the past two weeks alone, more than a dozen companies were forced to postpone or restructure debt sales.

``There are some very scary analogies between high yield and the mortgage market,'' said Kevin Lorenz, a managing director who oversees $2.5 billion of high-yield assets at TIAA-CREF in New York. ``You cannot do fundamental analysis and believe that those are creditworthy companies.''

Leveraged buyouts caused sales of high-risk, high-yield debt to rise 70 percent to a record $1 trillion during the first half of the year, according to data compiled by Bloomberg. Bonds and loans rated below BBB- by Standard & Poor's and Baa3 by Moody's Investors Service are considered below investment grade.

More securities than ever have the lowest rankings, with CCC ratings assigned to 26.5 percent of the new debt, according to New York-based Fitch Ratings. That compares with 15 percent in 2006 for debt that Fitch says has a ``high default risk.''

> i´ll bet thet this number was in the single digit just a few years ago....

Housing Woes

The combination of the worst slump in home prices since the Great Depression and the slowest U.S. economic growth in four years during the first quarter is driving investors away from riskier debt. The national median price for a previously owned home will probably drop 1.3 percent this year, the first decline since the 1930s, according to the National Association of Realtors in Chicago.

Traders demand 3 percentage points in extra interest to own U.S. junk bonds rather than government debt, compared with a record low of 2.41 percentage points on June 5, Merrill Lynch & Co. index data show. That's the fastest increase in spreads since April 2005, just before General Motors Corp. and Ford Motor Co. lost their investment-grade credit ratings.

>but still close to historic lows

Junk bonds lost 1.61 percent last month, the most since March 2005 when GM forecast its biggest quarterly loss since 1992. Junk bonds globally returned 2.88 percent in the first half, the lowest in two years, according to data from New York- based Merrill Lynch.

`Out of Control'

Investors withdrew $502 million from high-yield mutual funds in the week ended June 20, the most since September 2005, according to AMG Data Services in Arcata, California.

Fidelity International is ``underweight'' junk bonds, said high-yield bond analyst Sukrita Sethi in London. The firm owns a smaller percentage of the securities than is contained in benchmark indexes, suggesting Fidelity expects the debt to perform worse than other bonds.

``Demand has spiraled out of control,'' said Sethi, who helps oversee $2 billion at Fidelity International, an affiliate of Boston-based Fidelity Investments. ``We think the market is overpriced. There's a little bit more scope for spreads to tighten, but a lot more scope for widening.''

ServiceMaster Co., the Memphis, Tennessee-based owner of TruGreen LawnCare and Terminix pest control businesses, pulled a sale of $1.15 billion of bonds to finance a $4.7 billion leveraged buyout by Clayton Dubilier & Rice Inc., this week.

Meeting Resistance

US Foodservice, the caterer in Columbia, Maryland, purchased by KKR, Seoul-based automaker Kia Motors Corp., Banco Schahin SA in Sao Paulo and Rotterdam-based Arcelor Mittal, the world's largest steelmaker, were among companies that canceled or cut back more than $8 billion of borrowing in the last two weeks.

Some of the companies are meeting resistance because they want to limit standard investor protections, or covenants, such as restrictions on the amount of debt they can use compared with cashflow. So-called covenant-lite debt accounted for one-third of the high-yield, or leveraged, loans this year, according to S&P's Leveraged Commentary and Data unit.

Bonds that allow companies to pay interest in extra securities instead of cash, including toggle notes, accounted for almost 9 percent of high-yield debt sold this year, compared with less than 1 percent three years ago, Bank of America Corp. said in a June 21 report.

`About to Change'

KKR and Clayton Dubilier, both based in New York, planned to use toggle notes and covenant-lite loans in the $7.1 billion acquisition of US Foodservice.

When investors wouldn't buy the debt, the company reduced the amount of toggles, added cash-interest senior notes and agreed to a private sale of senior subordinated discount notes on June 22, according to Montpelier, Vermont-based high-yield research firm KDP Investment Advisors Inc.

Still failing to entice buyers, US Foodservice dropped plans for the toggles June 25. The next day, the company abandoned selling $1.55 billion of bonds and $1.57 billion of loans. Rob Meyne, spokesman for US Foodservice, didn't return calls seeking comment.

``Things are about to change,'' because companies will flood the market with junk bonds, said Ann Benjamin, head of high yield at Lehman Brothers Asset Management in Chicago, part of New York- based Lehman Brothers Holdings Inc. ``Some of those deals are overleveraged and will have weak covenants. We are going to be very cautious on the new issue calendar.''

US Foodservice

LBOs, acquisitions where buyers typically use debt for about two-thirds of the company's purchase price, are paying more in interest compared with earnings than at any time in the last 10 years, according to data compiled by S&P.

Earnings before interest, taxes, depreciation and amortization, or Ebitda, cover interest payments on their loans by 1.79 times, down from 2.32 times at the end of last year and a peak of 3.2 times in 2002, S&P data show.

US Foodservice's debt would have been 9.3 times its Ebitda had the LBO been financed as planned, according to KDP. The average leverage ratio for 271 companies rated BB or B was 3.6 times at the end of March, according to Fitch. S&P gave US Foodservice's notes a CCC rating, and Moody's rated them Caa2.

Bond and loan sales may be buoyed by demand from collateralized loan obligations, according to JPMorgan Chase & Co. high-yield strategist Peter Acciavatti in New York. CLOs package hundreds of speculative-grade company loans into securities with even bigger yields. Sales of CLOs doubled to $222 billion in 2006, and will probably increase 20 percent this year, according to JPMorgan estimates.

`Triumph of Liquidity'

The junk bond market rebounded each time it cooled in the past five years and Acciavatti, the top-ranked high-yield bond analyst in Institutional Investor magazine's annual poll for the past four years, says they will return 8 percent in 2007. The firm is the biggest underwriter of bonds and loans with ratings below investment grade, Bloomberg data show.

``It's the triumph of liquidity over fundamentals,'' said Peter Harvey, who oversees $3.8 billion of assets as head of credit at Cazenove Capital Management in London. ``The creation of credit funds is unlike anything we've ever seen.''

KKR co-founder Henry Kravis called this the ``golden era'' of buyouts at a conference in Halifax, Nova Scotia, in May. Yield spreads narrowed from the peak of more than 10 percentage points in 2002, saving companies almost $80 million in annual interest on every $1 billion borrowed in the junk bond market.

While defaults fell to 1.4 percent in May, the lowest in a decade, New York-based Moody's predicts they will more than double within a year to 3.4 percent of high-risk bonds.

Toggle Bonds

KKR's underwriters wound up holding $725 million of toggle notes for the firm's $7.3 billion acquisition of Dollar General Corp. when they couldn't find investors who wanted to buy them last month, according to a person familiar with the situation who asked not to be identified because the arrangement wasn't made public.

Goldman Sachs Group Inc., Citigroup Inc., Lehman Brothers and Wachovia Corp. bought the securities, and plan to sell them when demand improves, the person said. Goldman and Citigroup are based in New York and Wachovia is in Charlotte, North Carolina.

The bonds would probably trade at about 94 cents on the dollar, or $43.5 million less than face value, said Justin Monteith, an analyst at KDP. Dollar General's debt is likely to be 8.1 times the Goodlettsville, Tennessee-based company's Ebitda, according to KDP.

`Look Pretty Risky'

Tawn Earnest, a spokeswoman for Dollar General, didn't return phone calls seeking comment. Mark Semer, a KKR spokesman, declined to comment.

``Historically, a deal with six times leverage was a stretch but doable,'' said Mark Durbiano, who manages $3.5 billion of high-yield bonds at Federated Investors Inc. in Pittsburgh. ``If you take a US Foodservice, a Dollar General, they're all well outside that.'' Those deals all ``look pretty risky with this leverage,'' he said.

KKR plans to issue $8 billion of high-yield bonds to help finance its $25.6 billion purchase of First Data Corp., the largest processor of credit-card payments, according to filings with the U.S. Securities and Exchange Commission. The sale would be the biggest junk bond offering since RJR Nabisco Inc. in 1989.

The LBO firm, co-founded by Kravis and George Roberts, will raise another $14 billion using covenant-lite loans for Greenwood Village, Colorado-based First Data.

``When companies need to issue those types of securities they're acknowledging they're not giving themselves any wiggle room,'' TIAA-CREF's Lorenz said of toggle notes and covenant-lite loans. ``The market has gotten ahead of itself.''

Edited 2 time(s). Last edit at 07/05/2007 04:38AM by jmf.