Buyer beware

All the factors that have driven the leveraged finance boom – flush private equity houses, overcapitalised banks, a proliferation of institutional investors and dirt-cheap credit – are still at play. So it is tempting to think that the boom can run for a few more years yet, at least until borrowing costs or defaults (or both as they are related) rise substantially. And it probably can – but only as long as all parties involved become more discerning.

Deep liquidity might have slashed borrowing costs, loosened debt and covenant structures and enabled LBO technology to be used in an array of different financings, such as that of infrastructure projects. However, all the structuring in the world cannot make sense of what private equity houses around the globe are starting to do, and that is acquire companies that are ill-suited to being leveraged up and bought out.

Sponsors hate and reject the cliche that the main problem in private equity is that there is too much money chasing too few deals. Private equity houses insist that with the money and expertise they now have, there is almost no company too big for them to acquire and therefore no shortage of targets, especially as even big public companies, such as Danish telecommunications incumbent TDC, can now be taken private

That is probably true but it is a fundamentally different question as to whether many of these assets are suitable for leveraged buyouts and whether these deals make economic sense. Two recent deals, one in the UK and one in Australia, suggest the answer to both questions may well be “no”.

In the UK, NTL’s mooted leveraged acquisition of UK television broadcaster ITV is a case in point. The US-listed NTL is a shaky credit that owes £5.9bn and has only recently emerged from Chapter 11 bankruptcy. ITV is capitalised at £4.2bn, owes £700m and is profitable, but is struggling to hold its position in a declining sector where competition is fierce.

The idea of merging the two companies involves combining media content and delivery and reeks of the height of the last M&A boom, in which banks lost billions. And given that NTL has a US listing, meaning it will be difficult to make a paper bid for a UK company, financing would have to involve piling debt on to the creaking new company.

In Australia, news that Macquarie and Texas Pacific Group are mulling a circa A$10bn bid for flag carrier Qantas was just the latest in a string of large buyouts and buyout attempts that show the Australian LBO market has taken off in full and become the first market in Asia to do so. It also shows just how toppy the market has become.

Even ignoring the considerable regulatory obstacles to the buyout succeeding, such as foreign ownership and competition restrictions, Qantas does not seem an ideal buyout candidate. While it is as good a credit as one can find in the airline industry, thanks to its duopolistic control of the Australian market, the company is already heavily indebted. It owes about A$5.3bn and anywhere from A$4bn to A$6bn in aircraft leasing deals. Depending on how much of the company the sponsors seek to acquire, they will be looking to add a further A$4bn–$6bn in debt on top of that.

Furthermore, aviation is hardly an ideal sector for leveraged buyouts. The industry is heavily cyclical, has high fixed operating costs, is vulnerable to competition from new entrants, and is easily subject to external shocks such as terror attacks, high fuel prices and delayed aircraft orders.

None of this means that the right kind of deals, even giant transactions, cannot get done as long they are the right kind of companies and funded with the right kind of debt structure. Bankers have become very good at structuring their way around problems through the use of loans with back-ended amortisation, all-bond debt structures to avoid maintenance clauses, deeply subordinated instruments to maximise fund liquidity and the use of derivatives to hedge away price movement risk. And Macquarie Bank, one of the Qantas suitors, is a world leader in using such structuring technology.

However, all of the clever structuring in the world cannot make sense of an asset that is not suitable for a leveraged buyout. Perhaps it is the jumbo deals that are getting done around the world that make sponsors and their bankers think that anything is possible. In the US, deals are getting done even though they are getting bigger. KKR is acquiring HCA in a record US$33bn buyout but the record will not stand long because Blackstone Group has launched a US$36bn buyout offer for Equity Office Properties.

In Europe, KKR also sounded out French media and telecoms conglomerate Vivendi for what would have been a circa €40bn LBO. While the deal is not happening, one US bank is believed to have been willing to underwrite about €25bn of debt to support the LBO.

Vivendi would be a big target but given how much money sponsors have and how liquid debt markets are, funding could almost certainly be raised. The issue has become not so much whether such deals can be financed, for clearly they can, but whether they make sense at all.

Vivendi, for example, is a conglomerate so sponsors probably feel they could unlock significant value from its constituent parts and property portfolio. The same probably cannot be said for the likes of ITV and Qantas, which look more like being signs that sponsors are struggling to find ways to put their excess capital to work and of banks being only too willing to help them.