When will America's party end?

In an interview with the Wall Street Journal this past January, the notoriously reticent Kohlberg Kravis Roberts co-founder George Roberts brushed off two concerns – one, that the boom in private equity activity is a bubble and, two, that private equity firms are loading up the companies they buy with inordinate amounts of debt. Roberts reportedly said: “In 1987, the average deal was 93 percent debt and seven percent equity. In 2006, the average deal had 33 percent equity and 67 percent debt.”

Leverage levels in US private equity deals are indeed lower than they were in the fevered late 1980s and default rates on leverage loans are at an historic low. No surprise then that the party goes on. The private equity M&A and debt markets, fueled by low interest rates, are expected to break further records this year. As Ron Kantowitz, head of North America leveraged finance at Royal Bank of Scotland, says: “We're seeing larger deals come to the market with consistency. There's tremendous liquidity available, enabling sponsors to bring more aggressive structures to market supported by both banks and institutional investors.”

But many industry experts warn that it is only a matter of time before the party ends, although no one knows what will cause this: an oil shock, a spillover of trouble in the US sub-prime mortgage market, or some other event. There are also rumblings in the industry about the current aggressive forms and levels of debt being used to finance US leveraged buyouts, which may prove destructive when the liquidity tide turns.

Although the mood in the lending market is sanguine, some limited partners are beginning to worry. This may be compounded by the fact that there is nothing in the partnership agreement that restricts the amount of debt GPs can insert into the companies they buy. A recent survey conducted by San Francisco-based private equity advisor Probitas Partners found that the topmost concern among LPs is high management and transaction fees, followed closely by the unsustainable amounts of leverage in the market.

Average debt multiples for large corporate LBOs climbed to 5.7 times EDITDA at the end of 2006, the same level as in 1997. But default rates have trended in the opposite direction. Standard & Poor's Leveraged Commentary Data reports that the lagging 12-month default rate by number of loans fell to an all-time low of 0.45 percent at the end of March 2007, down from 0.79 percent at the end of 2006 and 2.08 percent the previous year. There were no new institutional loan defaults in the first quarter of this year.

There are companies that a few years ago, in a recessionary time, would have had difficulty refinancing but are now able to stave off that day of reckoning by refinancing because funding is so readily available

David Brittenham

“[Leverage multiples] are close to, if not at, record levels these days,” says Kantowitz, who notes that he has lived through several market cycles. He adds that the types, sizes and volume of private equity deals these days are “unprecedented. Generally speaking, the more aggressive structures and leverage multiples are being done at the large end of the market with the large cap sponsors.”

Of particular note, Sam Zell's recent $8.2 billion bid for Tribune will leave the newspaper company with more than $12 billion in debt, or about 10 times the company's cash flow. Which is not as high as broadcaster Univision Communications' debt level of 12 times cash flow. Another deal that has raised eyebrows is The Blackstone Groupled $17.6 billion acquisition of Freescale Semiconductor in September 2006. The Texan company, which operates in a cyclical industry, took on an additional $9.5 billion in debt, which prompted S&P to downgrade its bonds to junk status.

WHEN THE CYCLE TURNS
The huge amount of liquidity in the marketplace from both existing and new investors is creating a hazard in terms of the way in which it is easier for companies to refinance their debt with looser covenants, or none at all (see feature “Bankers take a back seat”, page 48). “There are companies that a few years ago, in a recessionary time, would have had difficulty refinancing but are now able to stave off that day of reckoning by refinancing because funding is so readily available,” says David Brittenham, a partner in the New York office of law firm Debevoise & Plimpton.

Many leveraged buyout financings today also require very little principal to be paid for several years, says a partner at a New York law firm who has worked on many innovative financing structures for top private equity firms. The normal amortization for term B loans is one percent per year, and high yield bonds require no amortization of principal.

More flexible structures for new debt financings may also pose problems for the holders of these loans when the tide does turn. Innovations such as second-lien loans, covenant-lite loans and toggle notes are now common, and sometimes even required, in private equity deals. But as Alexander Chan, US high yield analyst at Barclays Capital, wrote in a recent report: “This trend of non-traditional loans, however, needs to be examined because they have not yet been through a downturn. When the credit cycle turns, the recovery rates for these loans will likely be lower than the historical average.”

In the meantime, Kelly Deponte, partner at Probitas, points out that unlike in previous LBO cycles, sponsors are in no hurry to offload debt. “Now sponsors will buy a company and very often, within a year, will re-lever it and do a recapitalization,” he says.

A popular product for a private equity-backed dividend recapitalization has been the second-lien loan. At the end of last year, S&P announced that seven out of 10 second-lien loans in the US had a recovery rating of 5, meaning lenders can expect to recover between 0 percent and 25 percent of their principal in the case of a default.

For now, there are only a handful of companies that have trouble meeting their performance expectations or are breaching their covenants. However, things could change soon. Many now believe the default rate can only go in one direction: up. S&P chief economist David Wyss forecasts that defaults could become “more plentiful… two to three years down the road” as earnings growth in the US decelerates into single digits due to slower GDP growth and higher interest rates.

These ingredients are a potential recipe for disaster for highly leveraged companies. A recession in the US or elsewhere could cause a hike in interest rates and cause debt investors to pull back, as they did recently in response to a dip in the Chinese stock market. Former Fed chief Alan Greenspan in February predicted that a recession could occur in the US later this year, although he later clarified that the comments were not intended to communicate that he believed a recession was on the way.

A growing number of professional service providers predict work out son the horizon. Investment banks and law firms are preparing for a downturn by hiring more distressed debt and restructuring experts. For example, Harvey Miller, a legendary bankruptcy and restructuring lawyer, was lured back to Weil Gotshal & Manges after a four year stint at Greenhill & Co.

Another telling sign of impending trouble in the US leveraged finance market is the increased interest in distressed debt investing. A little over half of respondents to Probitas' survey named distressed debt as the niche market they were most interested in investing in in 2007, with equal interest in both restructuring/turnaround funds and distressed debt for control funds. There are also record volumes of distressed debt and turnaround funds in the market today. For example, Cerberus Capital is raising a $6.5 billion distressed debt fund, and distressed specialist MatlinPatterson is raising a $3.5 billion fund.

On the other hand, distressed pros have been expecting the party to end for at least the last two years, only to have their dire predictions drowned out by the sound of popping champagne corks.