Investors Starting to Choke on LBO Debt

One of the reasons the US market traded down today was fears the LBO boom is coming to an end, and support for that thesis came in a Bloomberg story, “Thomson Learning Shows `Breaking Point’ for Junk Debt.”

Three deals, Thomson Learning, US Foodservice, and Dollar General, are having trouble finding lenders on terms recently available. The Thompson deal had to be considerably restructured and reduced in size; US Foodservice merely had to increase rates. Dollar General appears to be meeting resistance but there was no discussion in the Bloomberg story of specific changes.

This is another sign of the end of a credit cycle. First we had the dramatic shift in sentiment in the bond markets two weeks ago. Now we are seeing more investors demand appropriate risk premiums (before they were absurdly low) and more reasonable terms (earlier this week, the rating agency Fitch had warned of deterioration in creditor protection) . Private equity firms, flush with cash, will strive to complete deals under the more stringent (but by any historic standards, still pretty favorable) lending environment. But with the supply of companies well picked over, and higher rates sure to slow the economy, it appears we are close to seeing a slowdown in LBO activity. And that reduces an important source of demand from the stockmarket.

From Bloomberg:

U.S. high-yield debt investors, after snapping up a record $600 billion in new loans and bonds this year, are starting to push back.

Thomson Learning, the textbook and educational testing unit of Thomson Corp., this week cut its bond offering to $1.6 billion from $2.14 billion, removed the riskiest portion of the deal and agreed to pay more interest on its planned loan, according to KDP Investment Advisors Inc. US Foodservice, a unit of Dutch supermarket company Royal Ahold NV, also raised the interest on its planned loan to attract lenders, Standard & Poor’s LCD said.

The concessions made by Thomson and US Foodservice may herald higher costs for U.S. companies seeking to finance a record amount of leveraged buyouts this year, investors said. Companies and their private-equity buyers are preparing to seek additional $300 billion in funding for takeovers including those of credit-card payment processor First Data Corp. and power producer TXU Corp., Bear Stearns Cos. said in a report this week.

“You push it until you hit a breaking point and maybe this is the breaking point,” said Mark Durbiano, who manages $3.5 billion of high-yield bonds at Federated Investors Inc. in Pittsburgh. “All of these big high-profile, highly leveraged deals that are currently out there are all struggling to find interested parties.”

Demand for bonds to finance Thomson Learning, US Foodservice and Dollar General Corp.’s LBOs is waning, Durbiano said. Thomson Learning is being acquired by London-based buyout firm Apax Partners and the Ontario Municipal Employees Retirement System. New York-based Kohlberg Kravis Roberts & Co. is buying Dollar General, the U.S. retailer with the most stores. Columbia, Maryland-based U.S. Foodservice is being bought by KKR and Clayton Dubliier & Rice.

Record Sales

Investors have swallowed a record $89 billion of junk bonds and $556 billion of high-yield loans this year, according to data compiled by Bloomberg. As demand for debt from buyers grew, companies were able to negotiate lower interest rates and fewer financial restrictions, or covenants. They also started selling bonds such as pay-in-kind toggle notes, which allow companies to pay interest with more bonds, rather than cash.

The extra yield, or spread, investors demand to own high- yield bonds instead of Treasuries has widened 0.15 percentage point to 2.66 percentage points this week, the biggest gap in a month, Merrill Lynch & Co. index data show. The spread reached a record low of 2.41 percentage points on June 5.

“The issuers and the underwriters really finally pushed too far, so they’re getting beaten back,” said Martin Fridson, chief executive officer of high-yield research firm FridsonVision LLC in New York. “They quickly went from six or seven times leveraged to nine times leveraged deals and they pushed on these covenant-lite and toggle” offerings.

Not `Good Quality’

Leverage, a measure of credit quality, is the ratio of a company’s debt to its earnings before interest, taxes, depreciation and amortization. US Foodservice will probably be leveraged 9.3 times after its takeover and Thomson Learning will be leveraged 10.7 times, according to KDP.

Thomson Learning dropped plans to sell toggle bonds as investors balked, according to a report by Montpelier, Vermont- based high-yield research firm KDP. Toronto-based Thomson Learning’s senior notes are rated Caa1 by Moody’s Investors Service and CCC+ by S&P, seven levels below investment-grade. Bonds rated Caa “may be in default or there may be present elements of danger,” according to Moody’s.

“The problem with this supply is it’s not of particularly good quality and the capital structures are very, very aggressive,” said Durbiano. “I think at the end of the day the structures will all be redone.”

Toggles Dropped

There is still demand for speculative-grade debt, just not deals that are this highly leveraged, Durbiano said. Eight U.S. companies cut interest rates on proposed loans in the past week, compared with four that raised rates, S&P LCD data show.

Debt rated below Baa3 by Moody’s and BBB- by S&P is considered high-yield, or junk. Investors withdrew $502 million from high-yield mutual funds the week ended June 20, the biggest redemption since September 2005, according to AMG Data Services in Arcata, California.

Thomson is now selling $1.2 billion of senior notes due in 2014 that will have cash coupons and $400 million of subordinated debt due in 2015 which won’t pay interest for two years, KDP said. Thomson also increased the interest in its $3.44 billion term loan by 0.25 percentage point and is offering the loan at a discount of 99 to 99.25 cents on the dollar, KDP said.

Adam Gaber, spokesman for Thomson, didn’t immediately return a call seeking comment. Bloomberg LP is the parent of Bloomberg News and competes with Thomson Corp. in selling information and trading systems to the financial-services industry.

LCDX Falls

A month-old index that allows investors to bet on the U.S. high-yield loan market has fallen for 10 straight days as banks hedge the risks from prospective deals and hedge funds use the index as a cheap way to bet ballooning debt loads will cause risk premiums to widen.

The LCDX index, which falls when perceptions of risk deteriorate, has dropped 1.66 since June 1, quoted at 98.93 today, according to broker Phoenix Partners Group. The prices imply that the cost to protect $10 million in bank loans included in the index from default jumped to $147,700 today from $105,000 at the beginning of the month, according to Markit Group Ltd., the index administrator.

“I don’t think it means a real cutoff of supply to the private equity firms yet,” said Fridson of FridsonVision. “But it might affect the pricing, how much they can pay for companies. They can probably rectify that by putting more equity into the deal, which they won’t like as it will bring down the expected return.”

US Foodservice increased the interest on its proposed $1.565 seven-year term loan by 0.25 percentage point and will now offer the debt at a discount of 99.5 cents on the dollar, S&P said.

US Foodservice also proposed selling $1 billion of eight- year toggle notes and $550 million of 10-year subordinated securities, according to KDP. S&P assigned the notes a CCC rating and Moody’s rated them Caa2.

US Foodservice is now planning to sell $550 million of cash- interest senior notes, $550 million of toggles and $450 million of senior subordinated discount notes, according to a person familiar with the sale who declined to be identified because the terms aren’t set. Rob Meyne, spokesman for US Foodservice, didn’t immediately return a call.

Companies sold $31.9 billion of bonds in the U.S. this week, compared with a weekly average of $24.6 billion in 2007, Bloomberg data show.

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