Cracks in the buyout boom

As investors push back on debt deals, the explosion of corporate buyouts could wane.

By Grace Wong, staff writer

LONDON ( -- Concerns that the best days of the buyout boom are over are growing as private equity firms are running into more difficulty securing financing for their deals.

Earlier this week, underwriters reportedly pulled a bond sale by U.S. Foodservice, which agreed last month to be bought by private equity firms Clayton, Dubilier & Rice and Kohlberg Kravis Roberts for $7.1 billion.

The sale and other loans backing the deal have been postponed due to weak market conditions, the Wall Street Journal and Reuters reported.

Dollar General (Charts, Fortune 500) is another firm being watched in the market. It's on the calendar to sell bonds related to its buyout, with pricing reportedly coming as early as Thursday. KKR bought the discount retailer in March in a deal valued at $7.3 billion.

Buyout firms are facing more difficulty as the subprime mortgage troubles at two Bear Stearns hedge funds are being felt in the broader credit markets - which is pulling investors away from risky deals.

The difference between yields on riskier junk bonds and safer government bonds has been widening, and analysts said that while there's no credit crunch yet, the tide is starting to turn in the market for lower-quality debt. That will make it more expensive for companies to raise money - especially those with weak finances - and more difficult for buyout deals to get done.

"Clearly concerns are spreading," said Dave Novosel, an analyst at Gimme Credit, a corporate bond research firm. "More deals are getting priced at much higher levels or aren't getting done at their initially proposed terms. I think we're starting to see the market turn for high-yield debt offerings."

The shift in the debt market comes as some of the largest junk bond offerings on record prepare to come to market. While those sales aren't likely to be derailed, analysts said some companies will find it more difficult to find investors to buy their bonds and bank loans that get sold off in pieces carrying varying levels of risk.

Buyout firms, which take companies private with mostly borrowed money, have benefited from a flood of cheap money in recent years. If they pull back, that could remove a key source of support for the stock market, which has gotten a big lift from the spree of companies going private. It could also lower returns for the private equity firms themselves and their investors.

Among the offerings investors are watching most closely are First Data's (Charts, Fortune 500) huge sale of junk bonds tied to KKR's $28 billion buyout of the payment processing company. At $8 billion, the sale would be the biggest junk bond offering ever, according to deal tracker Dealogic.

Wireless phone company Alltel (Charts, Fortune 500), which agreed last month to be taken private by buyout shop TPG (formerly known as Texas Pacific Group) and the private equity arm of Goldman Sachs (Charts, Fortune 500) for $28 billion, also has a massive sale in the wings. The company plans to issue about $7.7 billion in junk bonds.

The sheer size of these sales could pose some obstacles as there may not be enough buyers willing to swallow all of the bonds, analysts said. That represents a big change from just a month or so ago when investors hungry for higher returns had a seemingly endless appetite for corporate debt.

And as investors start to reassess their willingness to take on risk, companies with weaker financials that might have been able to raise money easily will start to feel the pinch.

"There are so many deals coming that do not have sound underlying financials. They will most likely have to pay up more, offer more covenants or there's the chance the deal doesn't get done - especially for lower-rated companies," Novosel from Gimme Credit said.

A seemingly endless appetite for risky debt has created one of the most favorable borrowing environments in years for corporations. Loans to highly indebted companies hit $681 billion last year, about triple 2002 levels, according to Fitch Ratings. Junk bonds haven't grown as rapidly but accounted for about 16 percent of all U.S. corporate bonds issued last year, according to the rating agency.

Buyout firms in particular have benefited from the boom, and have been able to finance their deals with relative ease. But investors may be filling up on the cheap debt that has fueled their party, some analysts said.

The widening of so-called yield spreads and pushback from investors "seem to be a reaction to issuers, and in particular private equity firms, pushing too far," said Martin Fridson, head of research firm FridsonVision, which specializes in the high-yield market.

Usually investors demand higher rates for riskier investments, but hedge funds, central banks and other big investors awash with funds to invest have been willing to buy debt from lower-quality firms without demanding as much of a premium in yield as in the past.

The latest problems in securities backed by risky subprime mortgages is a wake up call for the entire credit market, said John Lonski, who tracks global credit markets for Moody's. "There is less of a willingness on the part of lenders to assume as much risk as they were doing up until recently," he said.

Since the problems at Bear Stearns (Charts, Fortune 500) surfaced two weeks ago, the spread between high-yield bonds and comparable maturity Treasurys has widened to about 2.82 percentage points from about 2.60 percentage points, according to Moody's.

And while spreads have widened, they're still at historically narrow levels, though they're approaching the high for the year of 3.18 percentage points set in March. Furthermore, low default rates suggest credit quality isn't deteriorating much, at least not yet, which is why most analysts say a broad-based credit crunch isn't likely soon.

If the economy worsens, of course, all that could change, as it gets harder for companies to repay their debts.

But investors are already starting to reassess how much they're being compensated for their risk. The question now is whether this "repricing" of risk occurs in a slow, steady manner - or if there's a rush for the exits that unsettles investors, and markets, around the world.

"We hope it will be gradual, but there's no guarantee that we're not going to have another shocking development that leads to a contraction of credit great enough to widen yield spreads" for many types of debt, Lonski said.

This is an updated version of a story originally published June 26. Top of page