It?s not what you owe, it?s can you pay it?

With almost €20bn of new debt raised in 2004, distressed debt specialists are gazing greedily at those companies piling on the leverage. All the ratings agencies agree the current levels of leverage cannot continue. In a textbook example of stating the obvious, Moody’s says the default rate is likely to rise because much of the debt raised is rated in the lower rating categories and therefore liable to default later on. Speak to an analyst and they tend to be much less equivocal, and deal more in definites than likelihoods.

“What is going on at the moment,” says Daniel Morland, a director at Close Brothers Corporate Finance, “is that buyouts are a much more frequent and recognised model of acquisition than they used to be, from the mid-market to large buyouts. Increasing acceptance and a high amount of liquidity has led to what I would say is a bubble.”

While noone can say when the bottom will fall out of the debt market, or indeed what the trigger will be, most seem certain that such times are looming. “The average credit quality of new issuance was much lower than seen in recent years, more similar to that seen in 1999, three years before the apogee in defaults in 2002,” says Praveen Varma, vice-president of Moody’s, in a statement. “Such low quality issuance portends a significant increase in default rates over the next two to three years.”

What is still up for grabs is how to tell whether a company is going to feel the pain, ie what is the best measure of default risk. While this may not necessarily be something heating up the lunch meetings between GPs and LPs, it is an issue worthy of serious consideration.

The crux of the argument is this: it is not how much debt you have, it’s whether you can pay it off; leverage versus cash flow ratio. Dominic Slade, a partner at Alchemy, is such a proponent: “Leverage is nothing more than a very crude proxy. It does not give you an accurate indicator of affordability. Look at it like a mortgage. If you were asking for, say, a £150,000 loan and if the bank said we can give you £750 a month, you wouldn’t worry about how much the loan actually was but whether you could actually pay the £750 a month”.

Audrey Whitfill and David Gilmour, directors in Standard & Poor’s leveraged finance group, set out the basic premise: “The increasingly high levels of leverage seen in recent LBOs are reasonable (or justifiable) given the underlying business’s strong cash flow, ie cash flow ratios are more relevant than leverage ratios in evaluating these transactions. This premise assumes that so long as the company generates sufficient cash flow to meet its cash interest payments, the transaction is viable.”

However, this argument is itself not without its flaws, and Whitfill and Gilmour suggest it may be one-dimensional to think this way: “With increasingly high levels of debt, the company will need to apply substantially all of its free cash flow to servicing its debt. This impairs its ability to make the necessary capital expenditures, and with all cash servicing debt there is little flexibility or room to manoeuvre in the event of poor post-LBO performance. The transaction is even more heavily reliant on the continued stability of the underlying business and its cash flows to repay debt, and therefore the quality of the underlying business risk comes to the fore.”

The abundance of debt has thrown the whole debt/earnings ratio out of the window. Where the traditional model saw debt serviced by the (stable) cash flows the company produced, now, with supply outstripping demand, less stable businesses in less stable sectors are being highly leveraged. In the current climate, it is the borrowers that are calling the shots. “There has been a major shift over the past couple of years,” says Morland. “Historically, banks in leveraged buyout transactions would not allow sponsors to releverage the MBOs to redeem loan stock or pay dividends. Nowadays, there is so much liquidity that this is commonplace.” Banks aren’t in a position of power anymore, and so cannot demand lower debt levels, the restructuring of the bank debt or control equity withdrawals.

This is fine during the life of the transaction, so long as the company can continue to make its repayments, but a very real danger presents itself at maturity when the bullet or final repayment is needed. Whitfill says: “Repayment of the debt often depends on the ability of the sponsors to divest the company (through a trade sale or an IPO) with proceeds being used to repay the debt or, failing that, by refinancing the debt. The increase in refinancing risk is huge.” At the moment refinancing is not a problem for most (investors in Debenhams look away now), but this will not be a permanent state of affairs.

“By connecting the dots,” says Gilmour, “we see that while cash flow coverage of cash interest is important during the life of the transaction, especially when there is high or excess leverage, it simply sustains the company until the sponsors reach an exit point, either at some point during the life of the transaction, or at final maturity. If the sponsor is unable to exit or the transaction is unable to refinance, cash flow coverage of cash interest becomes irrelevant if the market no longer has an appetite for this type of transaction.”

The fear over macro and microeconomic conditions has already hit some sections of the finance markets. “The past couple of months have seen a major shift in sentiment in the bond markets,” says Morland, “and we are clearly past the point of inflexion. This is less evident in the bank markets, which tend to be more sanguine, although the change in sentiment will spread over time.” It appears it is no longer a case of if, but when.