Some LBOs Come a Cropper

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The Wall Street Journal features a story, “Boom Aside, Not All LBOs Look So Hot,” which reports that some LBOs are in trouble a surprisingly short time after the deal closed.

Now the Journal goes to some lengths to present these failures as deal specific by stressing that these cases are isolated, the economy is still strong, and so on.

But actually, the high concept of nearly all of these deals is so terrible that if they were movies, they never would have been produced. This fact begs the question of how experienced deal shops like Apollo (responsible for two of the dogs described) could possibly have signed off on these deals. Apollo likes turnarounds, but these deals suggest Apollo has been so eager to do deals that it has been experimenting with catching falling safes.

Start with Realogy, a residential real estate brokerage firm The deal closed in April. Residential real estate brokerage is in secular decline, thanks to the Internet, and cyclical decline. We and others have been saying the housing recovery is some way off due to a considerable overhang of unsold homes. And even if the fundamentals were in better shape, a brokerage is a terrible business to own. It’s like buying an ad agency, or a consulting firm. The best people leave to set up their own shop, and if you try to intervene in the operations in any way that the staff doesn’t like, they depart in droves.

Or consider the buyout of Freescale Semiconductor. Semiconductors are cyclical and capital intensive, so they aren’t a natural fit for private equity to begin with. Freescale’s biggest customer is Motorola. Motorola is not only in a mess, but it has a long history of having its divisions run almost as independent companies, which makes it very difficult to effect change. It does have a strong balance sheet and is sitting on a ton of cash, but neither of those help Freescale. Hoping on Motorola’s recovery is a dumb strategy, and finding new customers at the end of a business cycle that has had stingy captial expenditures isn’t a cakewalk.

So these may just be isolated bad deals. But we have a clutch of them done by seasoned firms. We’ve seen this movie before. At the end of the last LBO wave, in the 1980s, the deals done towards the end were considerably more dubious than the early deals, both due to the target companies having been well picked over by that point, and the increasing laxness of lenders enabled the buyout shops to patch together wobbly deals. At this juncture, let us not forget that economic conditions (if you believe this consensus rather than this blog), particularly corporate profits, are strong. For most companies, this is as good as it gets, performance-wise. So expect more deals to come a cropper.

In the workout phase following the 1980s boom, creditors would classify the deals into “good company, too much leverage,” which would lead to a restructuring of the debt, versus “bad company,” which generally led to a liquidation or other disposition of assets (like a breakup).

From the Wall Street Journal:

Even as the buyout boom rolls on, a number of recent high-profile deals are already showing signs of strain. Among them: the $1.3 billion purchase of retailer Linens ‘n Things Inc. by a group led by Apollo Management LP; Avista Capital Partners’ $530 million buyout of the Star Tribune newspaper in Minneapolis; and the $17.6 billion deal for Freescale Semiconductor Holdings by several buyout specialists. Apollo’s $6.7 billion purchase of Realogy Corp. also is raising questions among some investors.

For now, those deals are the exceptions — most of the recent private-equity buyouts have held up nicely or are at stages where it is too early to judge them, analysts and traders say.

“I think these are one-off problems and not a signal of problems to come,” says Victor Consoli, co-head of corporate-credit strategy at Bear Stearns. “The economy is still fairly strong, the dollar is weak, [which] makes our exports more attractive, and the consumer is employed and still spending.”

But others are more cautious, noting that recent LBOs have included heavy dollops of debt, potentially causing problems as bond yields climb and the U.S. economy runs into new obstacles.

Companies that have gone private in buyouts are generating cash that exceeds their debt interest payments by just 1.7 times, versus 2.4 times last year and 3.4 times in 2004, according to Standard & Poor’s Leveraged Commentary & Data. The ratio is at a 10-year low and shows how the margin for error for companies is shrinking as their profit growth is slowing.

Still, it is striking how quickly a few of the deals have run into problems. The stumbles from LBO firms with impressive track records are a reminder that these deals can be challenging, especially when they take place in cyclical or struggling industries where cash flows aren’t very stable.

“Our concern is if there is more of a slowdown in the economy in the second half,” more companies that have been taken private will run into trouble because of the significant debt they have taken on as part of the deals, says Jeffrey Rosenberg, head of credit strategy at Banc of America Securities.

This week, investors who purchased loans backing Avista’s buyout of the Star Tribune newspaper learned that the company’s cash flow already is running as much as 20% below Avista’s original financial projections for the deal, which closed just three months ago, according to someone close to the matter. Full-year results also are expected to come in below projections.

Some of the loans earlier this week dropped to around 96.5 cents on the dollar before rebounding to around 97.5 yesterday, according to data from S&P LCD. Such levels indicate investors are worried about the newspaper’s ability to repay its debt.

Avista has cut about 150 jobs at the paper and is hopeful the move will give it enough breathing space as it pursues growth areas, such as advertising over the Internet, according to someone close to the firm. A spokesman for Avista declined to comment.

At retailer Linens ‘n Things, which was bought by Apollo in February 2006, two consecutive quarters of poor results have sent prices of its bonds down 15% since late February to around 84 cents on the dollar. In an April report, Moody’s Investors Service said the home-furnishing retailer’s cash flow in its 2006 fiscal year was only $30 million, well below expectations of $166 million. Robert DiNicola, chief executive of the Clifton, N.J., retailer that is now part of Linens Holding Co., called first-quarter results “disappointing.”

“Linens is arguably showing some struggle — but it was marketed to lenders as a turnaround story — so the jury is still out,” Bear Stearns’s Mr. Consoli says.

A person close to Apollo said it viewed Linens as a longer-term turnaround, and the firm made sure the debt for the deal had no covenants, making it unlikely borrowers could force the company to pay off its debt early. That gives Apollo more flexibility to improve operations over time. An Apollo spokesman declined to comment.

Some traders are raising questions about Realogy, a residential real-estate broker that was taken private by Apollo in April and is battling a slumping housing market. Realogy, which doesn’t disclose its results publicly, likely went through a challenging first quarter with weaker sales and rising inventories, said debt research firm CreditSights.

A recent “alarming rise in existing home inventories” points to lower revenue and margins for Realogy, CreditSights analysts said. Yields on some of Realogy’s newly issued bonds have climbed to 13.1% from 12.75% when they were issued in April, as prices of the bonds have slipped, according to S&P LCD.

Freescale, meanwhile, reported weaker-than-expected results for its first quarter as the semiconductor maker experienced lower demand from its largest customer, Motorola Inc. Freescale suffered a drop in sales and cash flow, which prompted Moody’s to cut its outlook on the company to negative from stable, saying it expects Freescale’s cash flow this year to be weaker than anticipated, which would delay its debt reduction.

Some investors, however, say the recent weakness may present a buying opportunity, arguing that the private-equity firms backing the deals are skilled and shrewd enough to turn things around.

“We think there will be some blowups, but a lot of these deals are backed by smart investors who have written big checks,” says Kurt Cellar, a partner and portfolio manager at hedge fund Bay Harbour Management.

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