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Asia LBO default risk to rise?

US dollar-denominated LBO financings completed in Asia since 2007 could be next in line to experience the market disruption clause, but opinion is divided over whether this could push some of the target companies into distressed territory.

Those suggesting that a wave of defaults is expected from companies that were LBO targets are concerned about the added burden borrowers face if lenders invoke market disruption clauses. In an environment where a looming global economic recession threatens to shrink corporate earnings, any increase in costs will only compound the troubles.

The risk of the market disruption clause being invoked is higher in US dollar LBOs, particularly those that saw participation from small and second-tier lenders. In Asia, smaller South Korean and Taiwanese lenders are already experiencing difficulty in raising funds in the interbank market. As a result, a few of them have invoked the market disruption clause in loan agreements, passing on the increased costs to borrowers.

The most likely candidates among LBOs where the clause is expected to be invoked are those completed since the beginning of 2007. Leveraged finance specialists say that the risk of companies going into default cannot be underestimated as the global economy heads for a downturn, which could potentially hamper the earnings of companies, which in turn will affect their debt service ratios.

For financial sponsors, the distortion of their internal rate of return (IRR) calculations as a result of the increased debt costs means they will have to pump in more equity into the target or, in case of disagreement with lenders, prepay the debt.

However, equity cures are not available in all LBOs, depending on the documentation of the loan agreements. Moreover, private equity funds are also facing redemption calls from their investors, which means the target companies in LBOs might have no choice but to swallow higher interest costs.

Some LBO specialists, however, believe that the threat of default is being exaggerated. “LBOs done in Asia have largely been done with conservative leverage levels. Moreover, when these financings are put together, the financial sponsors would have typically built into their models assumptions relating to increased funding costs. They would have taken steps to hedge those risks,” said one banker in Hong Kong.

“Libor rates in the past couple of years have been on a decline. Although the rate is no longer a reliable reference rate and the invocation of the market disruption clause is highly likely, by itself it does not represent such a grave threat,” said another Hong Kong banker.

“If you did a back-of-the-envelope calculation, the increased interest costs following the invocation of a market disruption clause are insignificant. On a US$100m LBO, if the interest is increased by 1% per annum, that represents an addition of US$1m. If the LBO featured four to five times leverage, the added interest cost is small change,” concurred another banker in Hong Kong.

With LBOs generally paying high returns, some believe smaller lenders will not be inclined to invoke the market disruption clause. “A 50bp–100bp increase is not a lot for lenders who are already earning around 300bp over Libor,” said another banker.

Other leveraged finance experts disagreed, saying that the threat of default is very real. They believe that some of the aggressively structured transactions completed at the top of the leveraged finance cycle, particularly in Australia, will face challenges. Highly leveraged LBOs with bullet or heavily back-ended repayments are the obvious candidates.

“Should the global credit crunch prolong for longer than three months, the possibility of some of LBOs going belly-up is strong. Debt financings backing minority control are among the most likely to be hit, as they have generally been backed by underlying shares, the value of which has plummeted sharply. In such financings, the loan-to-value ratios are at severe risk of being breached and the consequences are not hard for anyone to imagine,” said a regional LBO specialist.

One banker suggested that one of the less painful ways to deal with the situation will be for companies to shoulder the added interest costs by issuing payment-in-kind (PIK) instruments.

However, the bank market has generally been averse to PIKs and Australia is probably the only market to have seen the instruments being employed on LBOs. Moreover, with the institutional investor base also having shrunk tremendously, there is virtually no appetite for such instruments.