If the private equity market were a race car, junk bonds would be high-octane fuel. Gentlemen, start your engines, because 2003 is zooming to become the largest year ever in terms of total issuance in the US high yield debt market. The rejuvenation of the junk bond means abundant financing options for private equity firms. It also means firms need not put as much equity into deals, which can improve returns. Large buyouts on both sides of the Atlantic are being fueled by the increasing availability and affordability of US high yield debt.
After thriving throughout the mid- to late-1990s, the high yield market went into a slump in 1999 and 2000, during which new issue volume slipped significantly (see chart). The market then saw a slight rebound in 2001, only to be followed by a newissue drop in 2002. This year, however, the new-issue volume is expected to increase back to 1999 levels near $500bn. As of September 30, 2003, there have been approximately 100 new issues of high yield debt totaling roughly $450bn. The total size of the high yield market, including new issues and all outstanding bonds, has increased to $873bn from $853bn a year earlier, according to research by Credit Suisse First Boston.
?It's been a great year,? says Mark Alter, a managing director at The Carlyle Group. ?For people who were patient with this asset class this past year, they've been rewarded.? Alter and his colleague, Ronald Grobeck, manage Carlyle's high yield debt investment funds. They also lend insight on the high yield debt market to Carlyle's private equity investment groups.
Grobeck credits the junk bond market's recent recovery to the natural capital market cycles. ?High yield bonds are affected by equity valuations and interest rates,? Grobeck says. ?There was a movement to this asset class because returns in other asset classes had been weak or negative and this was an attractive haven. When funds came in, it helped to further drive the recovery in this market.?
Of course, a solid recovery in the high yield market doesn't mean that just any company will be able to raise high yield debt easily. That is something for a private equity firm to consider when it is looking to complete a buyout. Back in the late 1990s, companies without solid cash flow streams, including huge telecommunications startups, were able to sell non-investment grade bonds. No longer. High yield debt investors now insist on companies with verifiable cash flow – just the kind of companies that mainstream buyout firms back.
?You're seeing a lot of companies with fairly good cash flows and good track records get access to the high yield market,? Ted Stenger, a principal at turnaround consultant AlixPartners, says. Stenger is currently serving as the treasurer of discount retailer Kmart and has much experience dealing with high yield creditors. He adds that as time goes on, the natural economic cycle will allow more companies to raise high yield debt, perhaps even ones that don't exhibit especially stable cash flows.
recent example of a private equity buyout that accessed the high yield debt market is Thomas H. Lee Partners' acquisition of food company Michael Foods from Vestar Capital Partners. That transaction, which was valued at approximately $1.05bn, includes a $200m junk bond tranche that was rolled over from Vestar's and private equity firm Goldner Hawn Johnson & Morrison's original privatisation of Michael Foods in 2000 for approximately $800m.
According to Anthony DiNovi, a managing director at Thomas H. Lee Partners, junk bond financing is currently available at attractive multiples. ?We financed [the Michael Foods acquisition] at 5.5 times trailing EBITDA,? DiNovi says. ?That was less leverage than was available but we prefer to have a more conservative capital structure.?
DiNovi also notes that high yield lending multiples currently range from 4.5 to 7 times EBIDTA, depending on the type of company being financed, its cash flow and the general demand from the marketplace.
James Kelley, the president of Vestar Capital Partners, adds that another factor in a company's ability to raise high yield debt is whether or not the company has raised such debt in the past. ?A company like Michael Foods that has performed well, coupled with the decline in interest rates, has an increased high yield debt capacity,? Kelley says. ?They're proven issuers.?
Popular metal benders
Proven issuers tend to be ?old economy? companies. According to Steven Rattner, a managing director at DLJ Merchant Banking Partners, which is part of CSFB Private Equity, a company's ability to raise high yield debt is greatly affected by what industry the company is in. Rattner says a ?traditional metal bender? that doesn't see much volatility in its business can probably access high yield debt at a multiple of 4.75 to 5.25 of EBITDA. He adds that these multiples have expanded over the past year.
Clearly, investors are now more willing to take on the risks typically associated with high yield bonds. ?People have money to spend and are looking for yield, so they're willing to invest in slightly more levered transactions,? Rattner says. ?That cash has led to a good appetite for new issues of all types, but in particular, for leveraged buyouts, which generally have higher overall coupons than corporate refinancings.?
Another factor investors consider when vetting a high yield debt offering is the plan of action of the equity sponsor, according to AlixPartners' Stenger. Investors want to see how a private equity firm plans to help grow the business.
A similarly important factor is a company's management. Investors want to see that the management team is competent and has proven itself in different business environments. ?People are really looking for man agers with longevity,? Stenger says. ?That's gotten harder to measure from the outside if for no other reason than the turnover rate in management positions has compressed dramatically in the past two or three years.?
The opening up of the high yield market is directly affecting the deals of only the largest private equity firms. Most transactions that involve high yield debt have values of more than $100m and often greater than $150m. In the mega-deal market, the importance of high yield debt cannot be overstated – the high yield debt tranche of these transactions can sometimes be as much as 50 per cent of the capital structure, according to market experts.
Across the pond
Despite its riskier nature, the high yield market continues to be an attractive place for companies to raise financing, whether for operations or for leveraged buyouts sponsored by private equity firms. In fact, the US high yield market has become important to European private equity. Europe's high yield market is not nearly as developed as its counterpart in the US, in large part because its growth was hampered by issuances from weak companies in the mid-1990s, according to Rattner.
?We've seen a lot of European companies come to the US market because they're reasonably capitalised,? Carlyle's Grobeck says. As an example, he cites Carlyle's acquisition in July of Fiat's aerospace business, Avio, for €1.5bn. The high yield debt financing used in that transaction was raised in the US.
Alter points to another transaction – the leveraged buyout of water purification company Nalco by a private equity trio comprised of The Blackstone Group, Apollo Advisors and Goldman Sachs. Part of that transaction will involve a high yield tranche of approximately $1.8bn, half of which will be raised in dollars and half of which will be raised in euros. ?That's very common on a larger deal,? Alter says of the dual-market approach to high yield financing.
Junk isn't for everyone though. David Horing, a managing director of New York-based private equity firm American Securities Capital Partners, says his firm prefers not to use high yield because it imposes greater risk on a company than does bank financing. He adds that bank financing also can be done on a more personal basis, as private equity firms often have close relationships with lending institutions.
?If you work with a group of banks, you have a group you know and when things come up, you want to be able to sit down and talk to people,? Horing says. He also notes that bank debt is prepayable at no cost, which is not the case for high yield debt. If a company wants to pay back its high yield debt early, it is typically charged for the right to do so.
As the US economy improves, the high yield debt market can only grow stronger. Market observers predict that 2003 will be a banner year both in terms of new issues and the overall size of the market. According to DLJ's Rattner, the growth of the high yield market should continue through 2004.
Carlyle's Alter compares the resuscitation of the high yield market to the back-to-basics fervor that has swept the private equity world. ?In late 1999 and 2000, we were still funding VC-like debt investments,? Alter says. ?Those are no longer viable.? Again, what the high yield market demands is stable cash flows. As it gets larger, it seems to also have grown a little wiser.