A revival of leveraged buyouts in Europe has unnerved holders of high-quality corporate bonds because they are fearful that bond prices and credit ratings could plummet if acquirers load up companies with debt, analysts said.
Tomkins sparked speculation of a flurry of LBO activity in the UK engineering sector after it revealed that private-equity group
“It’s not going to be anything like we saw in 2006 and 2007, where we saw headlines practically every day about a large cap about to be taken private,” said Sarwat Faruqui, head of European corporate syndicate at Citigroup. “But it’s undeniable that over the last six months there is more noise about it being possible to raise money for LBOs.”
LBOs hurt existing bondholders because the target company’s balance sheet is loaded up with new debt by private equity buyers to pay for the acquisition. The increase in a company’s debt load can lead to credit rating downgrades and put pressure on its outstanding bonds.
Gary Jenkins
, head of credit research at Evolution Securities, said the Tomkins bid was a reminder of the risks credit investors face. “There are various covenants in bond issues, but they are not in all of them and they are different strengths,” he said.
Large LBOs are unlikely because raising vast sums of cash is still difficult; however, acquisitions of smaller high-grade companies are likely to pick up gradually, bankers said. “LBO risk isn’t nearly as bad as it was four or five years ago, but you need to be aware of it,” said Phil Milburn, fund manager at Aegon Asset Management.
Change of control language in Tomkins’s two sterling bonds–maturing in 2011 and 2015–means bondholders are relatively well protected. Investors have the option to sell the bonds back at par, and as a result the bonds only fell by about 3 points after the bid news to just above that level. Tomkins’s credit default swaps saw a more dramatic move.
Its five-year CDS doubled to around 300 basis points because of the uncertainty about which bonds would be deliverable against the CDS contracts. “If you’re playing in the CDS world, change of control is irrelevant. If you had sold protection on Tomkins CDS a week ago, you won’t be happy,” Jenkins said.
One London-based credit trader said he had seen more CDS buyers in UK engineering companies, driven by expectations that they might also be LBO candidates.
Andrew Sheets, a credit strategist at Morgan Stanley, said investors and private equity groups often target companies with a similar profile–low debt, steady cash flows and low valuations–making it tough for investors to strip out LBO risk.
Heightened LBO risk post-2005 resulted in more protective change of control language and structures have changed little since then, said Alexander Dill, an analyst at Moody’s. Change of control covenants are triggered if the nature of the business changes significantly as a result of a buyout, merger or major asset disposal, among other situations.
ISS bondholders threatened to sue the company in 2005 after its takeover by private equity groups sparked a six-notch rating cut deep into junk territory and a sharp fall in bond prices. It remains to be seen whether Spanish motorway operator Abertis– also the subject of a LBO bid–will keep its investment-grade status. S&P has warned it may cut the company’s BBB+ rating due to uncertainties about the new ownership structure.
European bondholders may be less at risk if the financing for LBOs is done in the capital markets rather than the loan market because few European bond issues have negative pledge–or liens covenant–protection, Dill said. Such covenants prevent the private equity group from subordinating bondholders when issuing new secured bank debt.
—Natalie Harrison is a Reuters correspondent in London
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