Like elsewhere in the corporate world, private-equity firms specializing in leveraged buyouts (LBOs) are on the march in Australia. Indeed, a string of deals in the past year, including tilts for airline
Qantas and retailer
Coles, show that LBOs are now part of corporate life in Australia. Their impact is only likely to increase.
Driven by cheap debt, perceived lazy balance sheets, buoyant economic conditions, increasing disclosure demands on listed companies, and a short-term-focused public-equity market, private-equity funds have never had it so good. And up to now, it's been a relatively smooth ride for LBO sponsors and investors.
Inevitably, the credit and liquidity cycle will turn, and the fallout could be deep. This heightens concerns over who bears the risks of these debt-laden transactions, and whether the risk-takers are being appropriately compensated and rewarded for the downside risks involved. Existing lenders, new lenders, and the LBO target company itself are all potentially exposed, especially with more aggressive funding structures becoming de rigueur. Even "mum and dad" retail investors--usually a group of risk-averse money lenders--are increasingly, and perhaps unwittingly, playing a key and high-risk role in funding LBO deals in Australia.
Private Equity—The Good, The Bad, And The Ugly
In its purest form, private equity plays an important role in addressing some of the inefficiencies of public capital markets. Buyout firms can temporarily remove underperforming assets from the short-term-focused public-equity markets to undertake necessary, but in many cases painful, restructuring to improve returns and competitive positioning.
For all the benefits, however, private-equity firms rely heavily on financial leverage to "create value" and magnify returns. Although very high debt levels can provide management a strong incentive to maximize earnings and capital efficiency, the risks of excessive leverage are substantial. Highly leveraged companies are particularly vulnerable to refinancing risks, particularly as the cycle turns and liquidity diminishes. Moreover, debt-laden companies have a significantly constrained capacity to accommodate cyclical earnings weakness or to respond to changing competitive and market conditions.
Standard & Poor's Ratings Services' global experience of LBOs isn't pretty: the credit ratings of acquired companies typically fall to the 'B' or low 'BB' speculative-grade ratings. At these ratings, probability of default increases substantially, with a 'B' rated issuer historically having a one-in-three probability of default over a 10-year period.
LBO activity in the Asia and Pacific regions has grown substantially in the past 12 months, with Australia and New Zealand accounting for more than half of total activity. The number of transactions completed in 2006 also highlights the breadth of industries susceptible to the private-equity phenomenon (see chart 1 and 2).
Chart 1
Chart 2
LBO Financing—Not All Debt Is Created Equal
A key characteristic of LBO funding structures is that they incorporate multiple levels of capital with significantly different risk profiles. In this respect, recovery expectations for each level of debt become a key driver of risk given the relatively high probability of default of these transactions. Although senior secured lenders often enjoy reasonably strong recovery prospects, the situation for junior secured and subordinated debtholders is substantially weaker (see table 1). For this reason, it would be rare for Standard & Poor's to assign recovery ratings any higher than '5' to subordinated LBO debt; this indicates recovery prospects of anywhere between zero and 25% of principal.
Table 1
Typical LBO Financing Structure
Capitalization
Senior secured debt
40%-55%
Junior secured debt (typically positioned close to operating assets)*
*Existing debt raised at the parent company level typically ranks in line with either the junior secured or unsecured/subordinated debt depending on the nature of the guarantee arrangement for the instrument. In some cases, however, poorly drafted debt agreements can result in debt providers ranking below junior unsecured debt.
Although LBO equity providers assume the first loss position in a default, their return profile is commensurate with the expected risks. However, the situation for debt providers is less clear, given that they do not participate in the equity upside but are heavily exposed to the downside risks. Furthermore, these risks vary significantly across the various layers of debt.
Senior secured lenders
Despite being exposed to relatively high default risk, senior secured lenders benefit from first ranking security and strong covenant control over the financed assets. This structure allows these lenders to step in and control cash flows and pursue a sale or recapitalization of the business in the event of significant operating underperformance. Accordingly, senior secured lenders can often enjoy relatively strong recovery prospects following a default, which significantly reduces their expected loss given default.
Standard & Poor's notes, however, that deal structures are increasingly becoming more borrower-friendly as the liquidity boom continues. These borrower-friendly or so-called 'covenant lite' transactions relax amortization requirements and reduce lender control over the financed assets. A continuation of this trend is expected to exacerbate the impact of any deterioration in market conditions and result in significant losses for lenders.
Subordinated/hybrid lenders
The unsecured and subordinated lenders to LBO funding structures bear a substantially higher risk profile than the senior secured lenders. These instruments are not only deeply subordinated, but cease paying interest well ahead of company default to protect the position of the senior lenders. Although unpaid interest is often cumulative, this can be of little value if the business never recovers and senior lenders step in to recover their own losses. Furthermore, pay-in-kind notes that cumulate interest in the early years of a transaction are even more exposed; noteholders may receive negligible income or capital returns from their investment in the event of default.
Of growing concern in Australia is that 'mum and dad' retail investors are increasingly being targeted to provide some of the high-risk subordinated debt funding for these transactions. These instruments can offer retail investors a seemingly attractive yield of 300-400 basis points (bps) over swap; however, the risks can be substantial. This return is only 100-200 bps above the senior secured debt, even though these lenders are exposed to a substantially higher expected loss given default due to their subordinated recovery position.
Retail investors are typically targeted where the issuer is a household name with strong brand appeal: for example, Myer Notes, BIS Cleanaway Notes. Although institutional investors also participate in these instruments, retail investors play a key role in driving demand and take-up. Unlike institutional investors, retail investors rarely have sufficient investment diversity to accommodate the significant risks associated with these instruments.
Given these subordinated retail instruments in Australia are typically unrated, it is difficult for retail investors to readily understand the risks of these complex instruments. Furthermore, given there is a strong disincentive for arrangers of these transactions to seek a credit rating—because of the clarity it would provide regarding the instruments' default and recovery prospects—it appears that retail investors will be "on their own" for the foreseeable future.
Existing "rollover" lenders
Although change-of-control and other LBO-protection mechanisms have become more prevalent in new Australian debt issues in the past 12 months, many existing lenders who don't benefit from these protections are significantly exposed to LBO-related risks. These lenders can often find themselves the weakest positioned of all debt providers in the event of an LBO. New LBO debt is typically raised at, or close to, the operating-company level, which can leave existing lenders at the holding-company level structurally subordinated to all new LBO debt. Furthermore, existing 'rollover' lenders receive no compensation for bearing these additional and unexpected risks.
How Will Corporate Australia Respond To Private Equity?
Despite the cyclical drivers of LBO activity, the threat for Australian companies is real. No longer can company boards assume that a strong operating performance will guarantee protection from the clutches of private equity. Any company is vulnerable where there is a perceived difference in value between the public and private capital markets. And while debt costs remain low and ample liquidity is available for private-equity players, the threat for corporate Australia will continue. As a result, company boards are assessing their options to minimize the attention of private equity and increase value for shareholders.
Capital return to shareholders
Given private equity relies heavily on financial leverage to fund acquisitions, regearing a balance sheet can soak up some of a company's excess debt capacity. It is critical to note, however, that a company's 'debt capacity' is a subjective measure and is typically determined by the prevailing appetite of the highly cyclical credit markets.
Increasing debt levels will, nevertheless, expose the company to many of the same risks arising under an LBO itself. A rising interest rate environment and adverse changes in a company's market or competitive environment can create significant medium-term risks. Even a company that regears its balance sheet to the low-investment-grade level may have little flexibility as market conditions weaken, resulting in a loss of its investment-grade rating and markedly higher funding costs.
In addition, companies may sell-off noncore assets and return the proceeds to shareholders. This can also weaken credit quality via a more narrowly focused asset and earnings base and reduced flexibility.
Business restructuring
Australian corporates can also respond to an LBO threat by undertaking aggressive business restructuring to replicate a private-equity strategy and improve earnings. Aggressive restructuring can, however, prove significantly more challenging under the scrutiny of the short-term-focused public-equity market. And such as scenario doesn't guarantee private-equity players will simply walk away.
A prime example of this is Coles Group's response to an unsuccessful private-equity approach in the second half of 2006. Following the approach, the listed Australian retailer articulated a very aggressive and multi-faceted restructuring program to address areas of competitive weakness and substantially boost earnings in the next two years. It is likely that such a strategy would have been executed by Coles in a much slower and more conservative fashion in the absence of the LBO approach. In many ways, Coles is attempting to execute a private-equity-style business restructuring in the public spotlight, and arguably on a more aggressive timetable. Furthermore, due to public disclosure rules, Coles must broadcast its restructuring plans to its competitors, which can undermine some of the potential benefits.
Coles' recent announcement that it is reviewing its ownership options following further takeover approaches and a downgrade to its aggressive earnings forecasts for 2008 highlights that private-equity players are patient. It also underlines the significant challenges involved with executing significant restructuring programs in the public arena.
When The Cycle Turns, Lenders Beware
Despite all the euphoria, it is clear that when, not if, the cycle turns and liquidity dries up, defaults will rise and many LBO financiers, particularly subordinated lenders, will be significantly exposed. Importantly, these risks are only expected to heighten in the near term as competition for new transactions and ample liquidity encourages more aggressive funding structures and inflated asset prices.
Accordingly, it is critical that lenders structure and price their investments in the context of a weaker market cycle, and insist on strong and comprehensive covenant packages to manage the inherent risks. It is clear that if the risks borne by LBO debt investors are well understood and appropriately priced, it should go a long way to limiting the number of unsuitable LBO targets and overly aggressive funding structures completed in the current cycle.
Related Articles
Credit FAQ: LBOs Loom As A Key Threat To Australian Credit Quality , published on Ratings Direct on Aug. 29, 2006.
Recovery: No Longer The Poor Relation In Australian Corporate Credit , published on Ratings Direct on Dec. 5, 2006.
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