Leveraged Buyout Mania

The LBO craze continued today with Sallie Mae going private for $25 billion.

Shares of student-loan firm Sallie Mae jumped about 18% Monday after the company agreed to sell itself to a group of private-equity firms and two major banks for $60 a share, or about $25 billion, the companies said Monday.

"We see some plausible financial logic behind these investors' interest in Sallie Mae. New investors may be able to increase SLM's financial leverage, thanks to their willingness to forgo an investment-grade corporate credit rating and $200 billion of backup financing from two bank owners," Prudential analysts wrote Monday morning.

So the "plausible rationale" is the increased leverage someone gets from turning corporate grade investments into junk. Lovely.

Rumors of the deal pressured Sallie Mae Bonds last Friday.

Corporate bonds of Sallie Mae sold off on Friday after a New York Times report that the student lender is in takeover talks with private-equity firms about a leveraged buyout deal that could be worth more than $20 billion.

SLM Corp bond spreads widened by 33 basis points. A spread represents the distance between the yield on a corporate bond and the yield of a Treasury note of comparable maturity. Wider spreads indicate investor uneasiness with developments at a company.

Earlier this week, New York Attorney General Andrew Cuomo said his office reached a settlement with Sallie Mae in which it would adopt a new code of conduct regarding student loans and would contribute $2 million to an education fund. On Wednesday Cuomo's office issued a press release that noted "revenue sharing agreements, university call center staffing by lender employees, gifts and trips from lenders to financial aid directors, and even apparent stock tips to financial aid officers."

Sallie Mae and Citigroup Inc dominate the student loan market and both were found by Cuomo to have engaged in improper lending practices. Last week Cuomo announced multi-million dollar settlements with eight universities and Citigroup unit Citibank.

LBOs wreck havoc on bondholders

While shareholders are happy the LBO craze wreaks havoc on corporate bondholders.

Bondholders in leveraged buyout transactions are much like uninvited guests standing outside a mansion watching the revelry at a lavish party they cannot attend. Once an LBO gets under way, bondholders watch their investment-grade assets slip into junk status while the owners of shares of the same companies receive premiums as high as 25%.

"If you are a shareholder getting a 25% premium, you are in a very good position, but if you are a bondholder, good luck," said Nick Riccio, a managing director of corporate ratings at Standard & Poor's.

Typically, private equity firms and other takeover artists issue large amounts of new debt to finance LBOs, often borrowing at least two-thirds of the purchase price. The increase in debt frequently pushes the ratings of the acquired companies' debt lower, and often they end in speculative, junk status.

Naturally, this chain of events is painful for investors who deliberately bought high-grade bonds in the first place to avoid speculative risk.

There are stirrings of revolt among bondholders as the current LBO wave shows no sign of slowing. In fact, there are published reports that a $100 billion LBO deal could be on the horizon -- to date the largest LBO on record is the $44 billion Kohlberg Kravis Roberts and TPG Inc. agreed to acquire Dallas-based power producer TXU Corp

The enormous pools of liquidity that private equity firms can generate mean that companies once considered too large to be takeover targets are now seen as candidates.

[After a leveraged buyout deal was announced for First Data Corp], First Data's corporate debt rating was cut five notches by Standard & Poor's to BB+, which is junk status.

Although it is unclear at what level First Data Corp bond investors will be compensated, the faint-hearted among them will not have to hold the debt for long and be left to wonder whether a bankruptcy is in the works. Yet many observers expect Kohlberg Kravis Roberts to maneuver to pay less than full value to the bond holders.

In some cases, bond holders are taking legal action against private equity firms. Holders of Equity Office Properties bonds, for example, hired a Paul, Weiss, Rifkind, Wharton & Garrison attorney who secured almost $225 million more than the face value of their bonds, according to published reports. Blackstone Group took Equity Office Properties private for $20 billion.

But not all bond holders want to pay legal fees and, in general, their options are rather limited. At the same time, private equity firms are not likely to be voluntarily generous with bond holders.

"Typically, to make these deals worthwhile, a firm will pay as little as possible to the bond holders," said Dominick DeAlto, a senior credit analyst with Robeco, Weiss, Peck & Greer.

This leaves holders of existing bonds with few weapons in their arsenal. "Unless a bondholder owns a bond issued under a contract or an indenture that has an ironclad protective clause that would be triggered by this specific (LBO) event," he is stuck, according to GimmeCredit's Levenson.

Part of the problem is that the current LBO craze is only about a year old. This type of transaction was popular in the late 1980s, but fell out of favor in the 1990s and did not become common again until 2006. That means that many existing corporate bonds were structured at a time when LBO worries were minimal so they were not set up to give investors protection against such events.

Standard & Poor's Riccio predicted that bond holders will become more militant in coming months, given that the LBO trend shows no sign of abating. "We are sensing a lot of concern on the part of the investment community about takeouts that do not carry protections for bondholders," he said. "We are certainly hearing of some frustration with the current trends."

Panic Buying

Who in their right mind wants to own corporate bonds when they can be turned into junk overnight? Spreads are absurdly low and odds of "An Event" occurring are priced far in the distant horizon when the reality is otherwise. Of course most debt issues are junk already which is still another reason to not own corporate bonds.

There almost seems to be a panic now to get into LBOs now before someone else does even though most of the deals make little financial sense on a risk/reward basis. The justification for taking over Sallie Mae seems to be increased leverage associated with junk funded of course with OPM (Other People's Money). Is the idea to scoop up every company that is not already junk, strip the assets, stiff the bondholders, and turn the debt structure into junk before someone else does?

Whatever the driving force is, layer upon layer of debt keeps stacking up for unproductive purposes. None of this activity adds to GDP. As for who is buying corporate debt....

Capital Flows Rise to $94.5 Billion.

Capital flows to the U.S. totaled $94.5 billion in February, the Treasury Department said. This is up from an inflow of $79.6 billion in the previous month. Foreigners bought $39.9 billion in corporate bonds in February and $14.5 billion in Treasury notes. They also bought $13.2 billion in stocks, down from $23.3 billion in January. They sold $2.2 billion in government agency bonds, after buying $20 billion in January.

Michael Gregory, a senior economist at BMO Capital Markets, said market awareness of the weakness in the subprime mortgage sector "came to a head" in February.

Economists said the capital inflow is enough to cover the U.S. current account deficit, which requires an average monthly foreign saving inflow of $65 billion.
But analysts detect some slowdown in foreign investment as interest rates differentials between Europe and the United States narrow.

"The monthly trend of foreign purchases of U.S. long-term securities seems to have downshifted to the $60 billion per month range," said Jay Bryson, global economist at Wachovia.

TREASURY INTERNATIONAL CAPITAL DATA FOR FEBRUARY



(click on chart for a better view)

Given that month to month data is very volatile, take a look at the yearly trends in the above chart. Foreign acquisitions of treasuries and agencies are sinking but corporate bond and equity purchases are rising substantially.

As long as the corporate bond market holds together there is going to be support to get leveraged buyout deals done no matter how risky they are or how little financial sense they make. In conjunction with what has transpired in housing, interest rates seem high enough to be chocking off much of the real economy but nowhere near high enough to choke off financial speculation that is not only happening at an insane pace, but is increasingly being financed by foreign capital flows into corporate bonds.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/