NEW YORK -- Private equity firms are piling so much debt onto the companies they buy that some are left with barely enough cash to make interest payments, according to bankers involved in the current wave of leveraged buyouts.
After past buyouts, the standard ratio of cash flow to debt payments has been around two to one, but recently the average has fallen to about 1.5 to one, and heading lower, these people say.
Some recent private equity deals are even dipping below a one-to-one ratio, bankers say, meaning the company, at least initially, will not generate enough cash to make interest payments.
"There's no question that risk has increased substantially," said Sean Egan, managing director of Egan-Jones ratings company.
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In a deal proposed by real estate magnate Sam Zell to take Tribune Co.
private, Tribune would have $8.4 billion in new debt and its cash flow would be about 1.3 times its debt payments, according to bankers involved with the deal. Analysts have said the company, publisher of the Los Angelese Times and Chicago Tribune, would have trouble paying off the debt.
The last time leverage levels reached this point was seven years ago, when many telecommunications and technology companies collapsed under a pile of debt.
"Let's use a real estate analogy. You have a borrower who has three times as much cash flow as he does for the mortgage payment, versus one who has nothing left at end of the month," Egan said. "Most of the corporate debt market is going from prime to subprime in short order."
Private equity firms buy companies and sell them a few years later, typically borrowing two-thirds of the money needed for deals. They've pulled off more than $420 billion of buyouts globally this year, more than three times the amount for the same period last year, according to Dealogic.
They have benefited from low interest rates and financing tools such as pay-in-kind notes, equity bridges, and covenant-free debt agreements. (For a recent item on equity bridges see [ID:nN27425646])
These tools, together with the drop in interest coverage ratios, are signs that levels of risk are increasing.
In 2004, the amount of earnings available to pay interest for the average company in an LBO was more than three-and-a-half times the amount of interest that had to be paid, according to Standard & Poors. In other words, for every dollar paid in interest, another $2.50 of earnings were available for taxes, dividend payments, and other uses.
Last year, that average fell to nearly two to one, according to the data, which exclude deals that are small or in the media and telecom sectors.
RISKY BUSINESS
Thomson Corp. said earlier this month it was selling its text book business for $7.75 billion.
Bankers and private equity investors involved in the auction said the interest coverage ratio was below one.
To be fair, Thomson's text book group had a big chunk of cash on its balance sheet, and the buyout firm that will own most of the business — Apax Partners — is expected to pursue a major cost-savings plan, sources say.
And the deal has a pay-in-kind option, which will allow the buyers to delay interest payments. Apax declined to comment.
Still, bankers say more deals in the takeover pipeline will have cash flows that barely meet, or won't meet, interest payments, and these deals may find cost savings tough to come by.
"It's no surprise, really, as there is more and more liquidity in the market," said Dave Novosel, a senior analyst at Gimme Credit, an independent credit research firm.
That liquidity is fed by, among other things, the more than 9,000 hedge funds in existence, with many of them keen to gobble up the debt produced by leveraged buyouts.
"It seems like the covenants and restrictions are getting looser and looser with more freedom, and easier money," Novosel said. "Are we about to cross a threshold? I think maybe we have but we won't know the result on a lot of these deals for four to five years."
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