Another One Bites The Dust: The Perils of Debt Syndication

I previously highlighted the perils of leveraged debt syndications. Another recent failed transaction is Veritas-the seventh broken Euro high yield deal this year. Veritas is a large complex cross border transaction. At $8B it is the largest LBO in 2015. Carlyle and GIC (Singapore’s sovereign wealth fund) agreed to purchase Veitas, Symantec’s data storage unit, in August. The deal takes place in a year in which private equity has faced high purchase prices due to competition from strategic acquirers. Thus, Carlyle likely paid a full price for Veritas.

Some details of the deal are as follows:

1)     Debt Underwriters: Bank of America, Morgan Stanley, Goldman Sachs, UBS, Jefferies, Barclays, Citi, and Credit Suisse.

2)     Original Financing Package: $2.45B term loan, Euro 760MM term loan, $500MM secured notes, and $1.775B unsecured notes. Both term loans were covenant-lite.

3)     Revised Financing Proposal (because the original failed): $1.5B term loan, Euro 760MM term loan, $700MM secured notes, and$700MM retained by the underwriters-never a good sign of the deal’s strength. Both term loans are covenant-lite.

4)     Leverage: giving full credit to pro forma EBITDA improvements yields leverage of 4.5X for the senior and 6.5X total debt. The trailing unadjusted EBITDA leverage is higher. Even at 6.5X pro forma, the level will raise regulatory concerns as it exceeds their 6X threshold. The issuer is rated B/B2.

Investor concerns include:

1)     Size: largest deal of the year.

2)     Business Risk: data storage and cloud uncertainty suggest high business risk.

3)     Leverage: see above.

4)     Difficult to Analyze: divisional buyouts are always hard to evaluate. You are concerned with historical parent cost allocations, and whether the standalone unit can operate as an independent business. Usually underwriters require a forensic accounting review, which is shared with potential investors to give them comfort regarding historical performance. The review reconstructs the historical financial statements. For some reason that was not required here. No wonder investors are reluctant to commit. How can you build reliable reliable debt service models off of unaudited divisional financial statements?

I don’t think the market is losing faith in leveraged debt. Rather this appears to be a poorly structured deal agreed to before the mid August correction by aggressive underwriters trying to win a prestige assignment. Sometimes you have to be careful about what you wish for as may just get it. The underwriters are now getting it.

J

Private Equity: Between a Dog and a Fire Hydrant?

S&P Capital IQ-LCD published a report on the largest LBO transactions of 2015. Some interesting observations include:

1)     Purchase Prices (as multiple of EBITDA): increased a full turn in the LTM from 10.25X to 11.24X. This is a new high eclipsing the pre-crisis 2007 record.

2)     Funded Debt (as multiple of EBITDA): relative flat at around 6.5X. Regulatory security has depressed leverage levels.

3)     Equity Levels (as percentage of capitalization): increased to 35% to compensate for higher prices and constrained leverage.

4)     Deal Size: unlike corporate acquirers were the large deals (over $10B) have reached record levels, current LBOs are smaller in size. The largest deal PetSmart is $8.9B. This is partly due to the absence of larger Public-to-Private deals.

This presents a problem for PE. High prices, stagnate leverage and high equity will hamper the IRR performance for current deals. PE is forced to compete against not only corporate strategic acquirers, but also thousands of PE firms flush with newly raised funds. The current level of PE dry powder is $540B and growing. PE firms are being forced to deploy their capital into more expensive deals.

Leverage levels, unlike in previous cycles, are unlikely to loosen anytime soon. Regulators are still concerned with leveraged loan debt levels exceeding 6X EBITDA. The 2015 Shared National Credit report indicates a majority of the special mention credits (i.e. criticized) involve leveraged loans. Specifically concerning to regulators is poor underwriting represented by weak covenants, back-ended repayment terms, reliance on refinancing, and inadequate collateral. It is understandable that banks driven by shrinking net interest rate margins are attracted to higher risk leveraged loans with their higher nominal returns. Underwriting such loans this late in the credit cycle means credit losses are likely to increase-especially in energy and leveraged loans.

All of this leads to lower expected fund returns. You can see this reflected in lower stock prices of public PE firms like KKR and Carlyle. The August and November market corrections could slow corporate strategic acquirers relative to PE. The tightening credit markets, however, will complicate financing terms, pricing and availability. So, as the saying goes, PE may find itself caught between the proverbial dog and a fire hydrant, which means things, can get a little wet.

J

How Private Equity Creates Value: A Look Back

Carlyle purchased the industrial fastening and packaging firm Signode from ITW in 1H14. The purchase price was 9X EBITDA. They contributed $885 mln in equity representing around 25% of the transaction. The leverage multiple was 4.5X FLD (loans) and 6.5X total with a B/B2 rating. So how did it workout for Carlyle?

There are four levers PE can use to create value:

1)     Buy Right (i.e. cheap): this is increasingly difficult in the competitive domestic PE market. Here, Carlyle appeared to pay about market as it was competing against other PE firms for Signode. Signode was attractive given its established customer base and low cyclicality. Result-neutral.

2)     Financial Engineering (i.e. leverage): Carlyle capitalized on aggressive debt market conditions to obtain a relatively full leverage level with loose loan terms (i.e. covenant lite). Carlyle’s reputation and large dollar amount of equity contribution probably helped creditors get comfortable with financing. The large leverage level illustrates that PE firms really do not care about risk adjusted returns. All that counts for them is nominal returns, which of course are amplified by leverage. Result-positive.

3)     Improved Operations: an initial move was to improve working capital efficiency by increasing accounts payable to 60+ days, which freed up millions. Remember free cash flow= EBIT X (1-t) + D&A- (CAPEX + Working Capital Increases). Additional efficiency improvements and cost cuts were also planned. These were possible as Signode was no longer a division of ITW, but now a motivated highly indebted LBO. Result-positive.

4)     Sell High (i.e. multiple expansion): Carlyle signaled that they planned a liquidity event in 2016/2017. So far they are benefiting from an increase in PPX from the 9X paid last year to the current 10.5X. This combined with improved operations should provide multiple exit opportunities including a trade sale, dividend recap or IPO. Of course Carlyle cannot control market developments, but they can capitalize on them. Things can change before their planned value monetarization, but right now things look promising. Result-positive.

Bottom line, the transaction looks very promising despite Carlyle having paid a then full price. 

Most of the gains come from an old fashion carry trade (borrow and pay interest to acquire an asset with a higher cash yield) which appears to have worked out. Investors could have replicated the results by employing similar leverage to acquire stock in a comparable firm that would have also benefited from a rising stock market. Market timing is everything as other deals, richly priced at the wrong point of the cycle, like TXU and Caesars, have experienced trouble.

J