Read the whole thing here.
A look at recent buyout deals shows not only that they are getting bigger in dollar terms, but also that larger companies are being pushed to pile on increasingly heavy loads of debt.
Private-equity investors -- which make money by buying control of companies in the hopes of cashing out through a stock offering or outright sale -- have been emboldened by low interest rates and generous credit markets. They are pushing companies further out on a limb in the process. In some cases, this gives their newly private companies little breathing room to execute growth plans and stay afloat were economic and market conditions to turn sour.
In many cases, companies will need to devote at least half their yearly cash flow to meeting interest payments on their debt.
Corporations that were acquired in leveraged buyouts in the fourth quarter have a ratio of debt to cash flow of 5.7 times on average, according to Standard & Poor's Leveraged Commentary & Data Group. That is up from an average of 5.3 times in 2005. In 2002, when lenders were less willing to finance risky deals, this ratio was close to four.
The last time leverage in buyout deals averaged 5.7 times cash flow was during the merger boom of the mid-to-late 1990s. In the years that followed, some debt-heavy companies, like barbecue-products maker Diamond Brands and animal-feed producer Purina Mills, defaulted on their debt when their bets went wrong.
It's not all that surprising that these firms are highly levered - that's what the "L" in LBO stands for. In an LBO, the acquirer (a "private equity", or "PE" firm) takes a firm with decent cash flows that is arguably underleveraged and gears it up with more debt. This potentially creates value through a number of channels:
- The old risk-return tradeoff: Increased debt levels makes the firm's equity riskier, but magnifies returns in good times. So, why don't the managers of the public firm do this themselves? They might be too risk-averse to take the debt up to ooptimal levels. If a firm restructures in banckruptcy, the CEO is often out of a job, and may have difficulty getting another one. Hence, too little debt.
- Tax shields - interest on debt is tax-deductible (this is known as the "tax shield" of debt).
- Debt helps manage agency problems: having a lot of cash makes a company's future less sensitive to recent performance. taking on more debt means that the firms has to look at every decision more closely, since they're walking a tightrope.
But, the process is full of risk. With greater risk comes a greater chance of failure. This is why PE forms make so much money - they're willing to take on the huge levels of risk that managers of publicly-held companies aren't.