L e v e r a g e d Buyout Primer J a n n e y Corporat e Credit
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1 L e v e r a g e d Buyout Primer J a n n e y Corporat e Credit M a r c h 25, 2013 A few key LBO announcements have reminded bondholders of the risks related to investing in corporate bonds. Since the start of the year, a few key leverage buyouts (for example, Dell (Baa1/A-/BB+) and Heinz (Baa2/BBB+/BB-)) have spurred a whole market discussion of the potential return of the LBO market. In the years following the recession, LBOs have been few and far between, as banks became more selective in providing loans and as investors held on to cash in light of global economic uncertainty. We explore the various aspects of an LBO from a bondholder perspective, and suggest ways for retail investors to protect themselves from the risk of an LBO. From a bondholder s perspective, an LBO is one of the most unfavorable credit situations, as it is purely for the benefit of the shareholders. A leveraged buyout occurs when one or more private equity firms acquire a company through the use of sizable debt issuance, leveraging up the company (hence the name). Usually, but not always, private equity firms look for companies in less cyclical industries with generally stable cash flows. These elements imply that the company, once levered up, can meet debt obligations. The goal of private equity firms when completing LBOs is to earn the highest possible return on the equity investment over a medium-term time horizon (usually 7 years) through aggressively refining and growing the company. Since 1997, the median equity contribution to an LBO is 34%, indicating that debt makes up the remaining portion, or 66%. Debt is a tool to supplement the private equity firms growth plans for the targeted business, limiting the amount of equity the firm needs to invest into the business in order to leverage the equity returns. Companies Ratings Post-LBO Dropped with the Increased Debt Load Jody Lurie Corporate Credit Analyst jlurie@janney.com See page 5 for important information regarding certifications, our ratings system as well as other disclaimers. Leveraged Buyout Primer Page 1 Ann Date Target Trans Val ($B) Rtg Pre-LBO Rtg Post-LBO Current Rtg Energy Future Holdings $44.5 Ba1/BBB-/BBB- B2/BB/BB- B3/CCC/CCC Apr- First Data 28.7 NR/A/A B2/B+/B+ B3/B/B Alltel 27.7 A2/A-/A Caa1/B+/B N/A Jul- Hilton Worldwide 25.1 Ba2/BB/NR B3/BB-/NR NR Alliance Boots 21.5 Baa2/BBB/BBB Caa1/B-/NR NR Archstone-Smith Trust 20.8 Baa1/BBB+/A- NR/BB-/NR NR Nov- Kelda Group 11.4 A3/A-/A NR NR Jun- HD Supply 8.5 NR B2/B/NR B3/B/NR Jun- Avaya 8.3 Ba3/BB/NR B2/B/NR B3/B-/NR Dollar General 7.2 Ba1/BBB-/NR B3/B/NR Ba1/BBB-/NR Oct- Puget Energy 6.8 Ba1/BBB-/NR Ba1/BBB-/NR Ba1/BB+/NR Jul-2011 Kinetic Concepts 6.3 Ba2/BB/NR B2/B/NR B2/B/NR Jun- Allison Transmission 5.6 NR B2/B+/NR B1/B+/BB- Nov-2010 Del Monte Foods 5.5 NR/BB/BB+ B3/B+/B+ Caa1/B/B Bausch & Lomb 4.5 Baa3/BBB/BBB- Ba1/B+/NR B2/B+/NR Jul-2010 NBTY 4.1 Ba2/BB/NR B1/B+/NR B2/B+/NR Claire's Stores 3.1 NR B3/B/NR Caa1/B-/NR Nov-2010 JCrew Group 3.0 NR B2/BB-/NR B2/B/NR Jun-2011 BJ's Wholesale Club 2.6 NR B1/B+/NR B2/B/NR Source: Janney FISR; Capital IQ; Company Reports; Moody s; S&P; Fitch
2 From a bondholder s perspective, an LBO is one of the most unfavorable credit situations, as it is purely for the benefit of the shareholders. First of all, the act of buying out a company requires significant new debt issuance, thereby causing credit ratios to soften meaningfully. Leverage, as calculated by debt to EBITDA, can rise to unfavorable levels: median additional leverage taken on during LBOs since 1997 is 4.9x for large companies and is 4.3x for middle-market LBO ed companies versus an average LTM leverage ratio of 1.8x for US investment grade credits. Second, the act of an LBO will cause bond prices of outstanding pre-lbo debt to tumble as credit risk increases unless certain bondholder protections are in place. Not only will leverage rise, but financial and business information on the company may also become less transparent once taken private. The ratings agencies, in turn, will drop their ratings from what were likely solid investment grade ratings (though sometimes higher rated high yield ratings) to low high yield ratings (usually low single B to triple C territory). Dell 21 Trade Closer to the Single B Index than Single A since LBO News Broke Being cognizant of a security s bondholder protection features is a prudent strategy to employ, and can help investors preserve principal in the case of an LBO. 6.5 % 6.0 % 5.5 % 5.0 % 4.5 % 4.0 % 3.5 % 3.0 % 2.5 % BFV USD US Industrial B 8 Year BFV USD US Industrial A- 8 Year DELL 4 5/8 04/01/21 LBO Rumors 2.0 % 20-Jun 16-Jul 11-Aug 6-Sep 2-Oct 28-Oct 23-Nov 19-Dec 14-Jan 9-Feb 7-Mar Source: Janney FISR; FINRA TRACE; trade size 250M for specific security The key is that an LBO pushes additional risk on pre-existing bondholders without their consent. While many LBOs have played out successfully, resulting in private equities exiting via IPOs or mergers with peer companies, others have gone awry, forcing restructurings or liquidations. As a result, there are several terms built into debt agreements that can protect bondholders against LBOs. Bondholder Protection Change of Control Provisions Bonds for companies that are viewed as having acquisition or LBO risk often times have change of control provisions embedded in their indenture. Usually, these provisions allow bondholders to put HNZ 28 and HNZ 32 Don t Have Change of Control Provisions like Other HNZ Bonds Leveraged Buyout Primer Page bps HNZ 6 3/8 07/15/28 - No Change of Control 450 bps HNZ 6 3/4 03/15/32 - No Change of Control LBO News 400 bps HNZ 3 1/8 09/12/21 - Change of Control 350 bps HNZ /01/22 - Change of Control 300 bps 250 bps 200 bps 150 bps 100 bps 50 bps 0 bps 1-Nov 13-Nov 25-Nov 7-Dec 19-Dec 31-Dec 12-Jan 24-Jan 5-Feb 17-Feb 1-Mar 13-Mar Source: Janney FISR; FINRA TRACE; trade size 250M for specific security
3 In the case of an LBO, a company would need to refinance any and all debt that contains financial covenant restrictions or else it would enter technical default. the bonds back to the issuer at 101% of par value in the event of a change in control (in which the buyer purchases a majority stake), usually combined with the event of a downgrade by the ratings agencies. Although the current environment, in which many investment grade bonds trade at high premiums, makes change of control provisions less useful than in more normal interest rate conditions, the provision adds protection for bondholders nonetheless. In the case of the pending Heinz LBO, for example, bonds that have change of control provisions are less likely to carry over LBO Flow of Funds (Simplified) Private Equity Equity (~35% Purchase Price) Source: Janney FISR Public Shareholders Proceeds LBO Target Debt (~65% Purchase Price) Lenders (Bank Debt, Senior Credit Facilities, High Yield Bonds, Mezzanine Debt) to the more levered company post-lbo versus those that do not, and therefore trade at much tighter spreads than their less bondholder friendly counterparts. Step-up Provisions Another embedded provision found in some bonds issued by companies risking downgrades into high yield territory is a step-up provision. While this provision is not necessarily directly linked to LBOs or LBO candidates, it is relevant in that an LBO is likely to cause an investment grade company to drop below the low triple B ratings level. A step-up provision provides for a higher coupon for every time a bond drops in ratings. Even though bondholders get a riskier company, at the least they are compensated to some extent for the extra risk of the credit with the new ratings. Note, however, that step-up provisions are not too common. Financial Covenants Many lower-rated bonds have financial metric covenants, including minimum interest coverage ratios and maximum leverage ratios, which restrict a company s ability to issue additional debt. These financial covenants serve to protect bondholders against LBOs, among other issues. In the case of an LBO, a company would need to refinance any and all debt that contains financial covenant restrictions or else it would enter technical default. Leveraging of the LBO Target (Simplified) Public Company (Investment Grade) Leverage = 1.0x Debt Outs = $1B Source: Janney FISR LBO Target Issues New Debt Private Company (High Yield) Leverage = 6.0x Debt Outs = $6B CONCLUSION Over the past few years, as the bond market became more of an issuers market due to the high investor demand, debt issued during this time period lacked strict covenants. Concerns that the LBO market is coming back may shift investors thinking to demand stricter covenant packages as means to protect investments. Being cognizant of a security s bondholder protection features is a prudent strategy to employ, and can help investors preserve principal in the case of an LBO. Leveraged Buyout Primer Page 3
4 The goal of private equity firms when completing LBOs is to earn the highest possible return on the equity investment over a mediumterm time horizon through aggressively refining and growing the company. Leveraged Buyout Primer Page 4 Select Largest Announced or Completed LBOs Since ($B) Ann Date Status Target Investor(s) Trans Impl d EV/ EV/ Prem: Val EV Rev EBITDA T-1 Day Energy Future KKR; TPG; Black Canyon; Quintana; $44.5 Holdings 4 PE arms of investment banks $ x 8.0x 15% Ann'd 2013 Dell Silver Lake; MSD Capital x 4.9x 3% Ann'd 2013 HJ Heinz 3G Capital; Berkshire Hathaway x 13.6x 20% Apr- First Data KKR x 13.4x 26% Alltel Goldman Sachs Merchant Banking; TPG; AXA x 9.8x 10% Jul- Hilton Worldwide Blackstone x 14.9x 32% Alliance Boots AXA; KKR x 13.1x 9% Archstone- Tishman Speyer; Lehman Bros. Smith Trust Capital x 25.8x 10% Nov- Citi Infra; GIC Special Invts; HSBC; Kelda Group Infracapital; M&G Invt x 10.4x 18% Jun- HD Supply Bain Capital; Clayton, Dubilier & Rice; The Carlyle Group x N/A N/A Jun- Avaya Silver Lake; TPG x 10.9x 5% 2012 EP Energy Apollo; Access Industries; Riverstone; Korea National Oil x 8.1x N/A CDW Madison Dearborn; Providence Equity x 14.3x 6% Goldman Sachs Merchant Banking; Dollar General KKR; Citigroup PE x 9.5x 31% US Foods KKR; Clayton Dubilier & Rice x 8.9x N/A Oct- Canada Pension Plan Invt; BC Invt; Puget Energy Macquarie Infra; Alberta Invt x 9.4x 25% Jul- Kinetic Apax; Canada Pension Plan Invt; 2011 Concepts Public Sector Pension Invt x 9.1x 6% Jul- HCR ManorCare The Carlyle Group x 13.0x 3% Jun- Allison Transmission The Carlyle Group; Onex x 9.7x N/A Nov- Del Monte 2010 Foods KKR; Vestar; Centerview x 9.0x 6% Aug- DuPont Perf 2012 Coatings The Carlyle Group N/A N/A N/A Bausch & Lomb Warburg Pincus x 15.2x 6% Sep Burger King 3G Capital x 9.0x 27% 2013 Ann'd Gardner Denver KKR x 8.3x 3% Jul NBTY The Carlyle Group x 7.9x 47% Source: Janney FISR; Capital IQ; Company Reports
5 Analyst Certification I, Jody Lurie, the Primarily Responsible Analyst for this report, hereby certify that all of the views expressed in this report accurately reflect my personal views about any and all of the subject sectors, industries, securities, and issuers. No part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. Janney Montgomery Scott LLC ( Janney ) Debt Research Disclosure Legend Janney may seek compensation for investment banking services for any company in this report in the next 3 months. The research analyst is compensated based on, in part, Janney s profitability, which includes its investment banking revenues. Additional information available upon request. Definition of Issuer/Company Outlooks Janney FIS employs a rating system which considers the company, but not any specific debt or equity securities of the company and is not making a recommendation with regard to any specific debt securities of the company. Outlooks reflect our opinion about how credit factors of the company may affect its credit rating(s). Positive: Janney FIS believes there are factors which point towards improving issuer or sector credit quality which may result in potential credit ratings upgrades Stable: Janney FIS believes there are factors which point towards stable issuer or sector credit quality which are unlikely to result in either potential credit ratings upgrades or downgrades. Cautious: Janney FIS believes there are factors which introduce the potential for declines in issuer or sector credit quality that may result in potential credit ratings downgrades. Negative: Janney FIS believes there are factors which point towards weakening in issuer credit quality that will likely result in credit ratings downgrades. Definition of Sector/Industry Ratings Overweight: Janney FIS expects the target asset class or sector to outperform the comparable benchmark (below) in its asset class in terms of total return. Marketweight: Janney FIS expects the target asset class or sector to perform in line with the comparable benchmark (below) in its asset class in terms of total return. Underweight: Janney FIS expects the target asset class or sector to underperform the comparable benchmark (below) in its asset class in terms of total return. Janney FIS Outlooks Distribution as of 03/25/2013 IB Serv./Past 12 Mos. Outlook Count Percent Count Percent Positive Stable Cautious Negative Benchmarks Asset Classes: Janney FIS ratings for domestic fixed income asset classes including Treasuries, Agencies, Mortgages, Investment Grade Credit, High Yield Credit, and Municipals employ the Barclay s U.S. Aggregate Bond Market Index as a benchmark. Treasuries: Janney FIS ratings employ the Barclay s U.S. Treasury Index as a benchmark. Agencies: Janney FIS ratings employ the Barclay s U.S. Agency Index as a benchmark. Mortgages: Janney FIS ratings employ the Barclay s U.S. MBS Index as a benchmark. Investment Grade Credit: Janney FIS ratings employ the Barclay s U.S. Credit Index as a benchmark. High Yield Credit: Janney FIS ratings for employ Barclay s U.S. Corporate High Yield Index as a benchmark. Municipals: Janney FIS ratings employ the Barclay s Municipal Bond Index as a benchmark. Disclaimer Janney or its affiliates may from time to time have a proprietary position in the various debt obligations of the issuers mentioned in this publication. Unless otherwise noted, market data is from Bloomberg, Barclays, and Janney Fixed Income Strategy & Research (Janney FIS). This report is the intellectual property of Janney Montgomery Scott LLC (Janney) and may not be reproduced, distributed, or published by any person for any purpose without Janney s express prior written consent. This report has been prepared by Janney and is to be used for informational purposes only. In no event should it be construed as a solicitation or offer to purchase or sell a security. The information presented herein is taken from sources believed to be reliable, but is not guaranteed by Janney as to accuracy or completeness. Any issue named or rates mentioned are used for illustrative purposes only, and may not represent the specific features or securities available at a given time. Preliminary Official Statements, Final Official Statements, or Prospectuses for any new issues mentioned herein are available upon request. The value of and income from investments may vary because of changes in interest rates, foreign exchange rates, securities prices, market indexes, as well as operational or financial conditions of issuers or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. We have no obligation to tell you when opinions or information contained in Janney FIS publications change. Janney Fixed Income Strategy does not provide individually tailored investment advice and this document has been prepared without regard to the circumstances and objectives of those who receive it. The appropriateness of an investment or strategy will depend on an investor s circumstances and objectives. For investment advice specific to your individual situation, or for additional information on this or other topics, please contact your Janney Financial Consultant and/or your tax or legal advisor. Leveraged Buyout Primer Page 5
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