Friday Letter Mixed messages

Alliance Boots and Chrysler’s problems at syndication spell doom for buyouts, according to headline writers, but the real picture is more complicated.  

When the subprime crisis in the US began to bite, the £11 billion buyout of Alliance Boots was held up as bellwether for the debt market. It duly ran into trouble, and talk of the sudden death of the credit boom has been rampant ever since.

Today, however, the market should hear confirmation that the lead underwriting banks JPMorgan, Deutsche Bank and Unicredit have been successful in syndicating the subordinated tranches of debt worth close to £2 billion.

The success will be a somewhat Pyrrhic victory for the underwriters.  To get the junior debt away they had to offer a significant improvement on the yield of both the mezzanine and the second lien loans, as well as a deep discount on pricing – as much as 95 percent of face value on the second lien.

It is a double whammy that will see the banks lose money on the syndication, particularly while they sit on £5 billion of senior loans for the time being. But before we mourn their loss it is worth noting they will recoup some of their losses on deal fees elsewhere in the transaction. And for all the time that demand outstripped supply in months gone by, they were making money hand over fist, often dropping the yield on offer as investors queued for access.

The banks won’t be crying too much either. At least the riskiest tranches of debt are off the books and what is left, bulky though it is, is a solid blue chip retail credit. Shifting the subordinated debt will allow them time to focus on selling the senior, while the market holds it breath to see whether the present difficulties are a “technical blip” or a fundamental crisis.

There are arguments on both sides. Bill Gross, the legendary bond manager at PIMCO, maintained in a note this week that the corporate debt market would not be isolated from the sub-prime crisis. He said the sudden liquidity problems in the high yield debt market was just the latest sign that there is a connection, a chain that links all markets and ultimately their prices and yields to the fate of the US economy.

The sell-off in equity markets in the US and UK yesterday underlined that connection as fund managers came to terms with the potential drying up of buyout bids.

However, a rival manager told PEO there was a good chance that once the shakedown in the debt markets had eliminated over-exposed hedge funds and some of the newer collateralised loan obligation vehicles, the market would return to normal. Albeit on improved turns for lenders.

Will global debt markets face contagion if the US crisis deepens? That is another question without a clear answer. The subprime troubles might pull in the horns of some of the US-based global banks, but elsewhere credit fundamentals should remain benign. Businesses are not going bust and the rate of bankruptcies is not increasing.

If it is just a technical blip, a case of severe indigestion caused by a couple of big deals at a time of reduced liquidity, then it won’t be long before the deals start to move again.

But everyone seems to agree on one thing: terms and pricing will be more to suit the lenders and not the buyout firms. Gross wrote: “[T]he tide appears to be going out for levered equity financiers and in for the passive owl money managers of the debt market. And because it has been a Nova Scotia tide, rising in increments of ten in a matter of hours, it promises to have severe ramifications for those caught in its wake. No longer will double-digit LBO returns be supported by cheap financing and shameless covenants.”

An unambiguous message at last.