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

Rue21: A Deal to Rue

Yield hungry investors have swarmed syndicated leveraged loans this year. It seemed that they were throwing caution to the wind. Anything and everything seemed possible. Then came Rue21-one of the biggest high profile deals to flop in a while. Rue is a rapidly growing value orientated teen apparel fashion retailer. It has added 500 stores over the past years, and is scheduled to reach 1000 stores by year end.

In May, Apax, a UK private equity firm, offered to buy Rue for $1.1B Acquisition with a $62 Mln breakup fee. An affiliated Apax entity already owned 30% of Rue. The offer represented $42 per share- a 23% premium to market, 1.2X sales and 9.2X EBITDA. Comparable multiples were 0.5X sales and 8.4X EBITDA. The premium represented Rue’s rapid growth potential.

Apax would contribute $280 Mln in equity with the balance financed by debt representing a FD/EBITDA multiple over 6X. The debt included a JPMChase, BofA and Goldman $530 Mln syndicated loan. The loan was richly priced at L+ 475 with a 1% LIBOR floor.  During the syndication, Rue announced disappointing sales and earnings due to a “challenging retail environment”. Same store sales fell 9.5% thru 3Q and by 12.8% in September. The syndication struggled, and the agents offered 20-25% discounts without success.  See Syndication.

Some observations:

1)  Aggressive leverage for a rapidly growing firm is always a challenge. Add in fashion retail and the margin for error is razor thin.

2)  The purchase price was rich leading to the need for increased leverage. It only made sense assuming Rue’s growth would continue.

3)  Unexpected performance issues during the syndication are always possible. Nonetheless, I wonder how unexpected this really was. First, simple extrapolation, which appears to be the case here, is dangerous when constructing projections for growth firms. A modest downside case would indicate how problematic the debt service would be if a slowdown occurred.

4)  Basic earnings quality analysis also suggested concern. Earnings are an opinion while cash is a fact. Despite Rue’s growing sales and net income since 2009, their free cash flow peaked in 2011, and fell in FYs 2011 and 2012.  Growth related, rapid CAPEX and inventory increases were part of the problem. This coupled with a performance decline suggests a) Rue must curtail its growth and b) Rue will have difficult time repaying its debt. Loan investors undoubtedly saw this, and declined to participate despite the original rich price and even with the substantial discount -  they would not bite.

Diminished growth means the purchase price and capitalization rationales are no longer valid. Apax should consider renegotiating the deal or walking away after paying the breakup fee. The banks would be happy. Rue’s current shareholders, of course, would be upset, but would still be $62 Mln richer. Discretion is sometimes the better part of valor.

J

PS - Just over two months until Acquisition Finance in Amsterdam (see side note or click here)

Big Banks, Leverage and the Smell Test

Federal Regulator's recently proposed tougher regulations for eight banks.  Will it hurt the economy?  Lobbyists for these banks think so.  My colleague, Joe Rizzi, says 'Not so fast'.  Read his interesting article that appeared in  the American Banker last week regarding Big Banks, Leverage and the Smell Test.