|This article appears in the January 5, 2007 issue of Executive Intelligence Review.
2006 Buyout Wave
Is Default Blowout of 2007
by Paul Gallagher
The fourth-quarter explosion of so-called "leveraged buyouts" worldwide, accelerated wildly in the final weeks of the year, marked on Dec. 18 by the announcement of $87 billion "worth" of such buyouts, the fourth day in three months in which at least $75 billion in leveraged takeovers was made public. The Dec. 18 buyout splurge involved $57 billion in new debt loaded upon the takeover target companies, two of the biggest of which were immediately downgraded from investment-grade to junk-debt status in the process. And the $87 billion does not include the $30 billion merger, also announced Dec. 18, of Statoil and Hydro, two oil companies substantially controlled by the Norwegian government.
With the 2006 "debt-leveraged takeover" bubble reaching $4 trillion in "market value," which is, in fact, largely just new borrowings from commercial and investment banks and hedge funds, this bubble is threatening many nations with corporate debt blowouts in 2007. Fully $500 billion or more of this "market value" in takeovers was done during December alone.
Apart from the looting of many target firms already involved, the leveraged takeover boom looks to many financial regulators like a corporate twin-bubble of the U.S.-centered housing/consumer-debt bubble now bursting. Estimates of household debt in the OECD countries are at roughly 90% of total GDP, compared to just 29% in 1990. But estimates of corporate debt in those nations by the end of 2006 will be close to 80% of GDP, compared to 55% in 1995; and it is the corporate debt which is exploding in volume now. The 80% level is well above that of 1988, at the collapse of the 1980s takeover boom, which was much smaller in volume than the current boom.) The Reserve Bank of Australia's just-retired chief Ian McFarlane, for example, is publicly warning that the whole Australian economy is "becoming leveraged," and could be producing a corporate debt-jump like that of Australian household debt, which has leaped from under 50%, to 150% of disposable income in the past decade.
The wild acceleration of takeovers has lifted the record totals to 33,000 mergers and buyouts "worth" $3.9 trillion in 2006. Over $1 trillion will be in pure predatory takeovers by "buyout firms"private equity and hedge-fund locustsas opposed to mergers between two companies in an economic sector. But even in the cases of mergers or buyouts of one operating company by another, the takeover costs are usually being paid in cashnot stock, as in the 1999-2000 merger boomand the cash is coming from terrific amounts of new debt, borrowed from banks, hedge funds, etc., on the basis of "leverage," another name for the promise of looting and destruction of the companies and their workforces. "Lenders are increasingly willing to arrange aggressive financing packages for corporate clients," is how the Financial Times characterized the debt-default bonfire being stoked up.
Moreover, private equity-fund predators were reported, as of mid-December, to have $200 billion more to put into mergers in the final two weeks of the year; with bank lending multiples typically of three or four to one, that could push the year's total to over $4 trillion, 20% above the previous record in 2000.
Effective action by governments to intervene and stop this destruction has been proposed and urged by Lyndon LaRouche. And in South Korea, the same principle has informed a crucial November decision of the Supreme Court, which found many leveraged buyouts illegal under clearly defined conditions (see box). The Republic of Korea Supreme Court decision indicates a precise model and political method for national legislaturesincluding in the United States, the epicenter of the buyout-bubble madnessto intervene to reverse it before the corporate debt bubble explodes in "leveraged defaults," blowing out the credit markets.
A Second Warning from Ratings Agency
The economics research department of the Standard and Poor's debt-rating agency put out a warning report on Dec. 14, about a coming wave of "leveraged debt defaults" threatening the international credit markets. This means rapid-fire, and potentially massive defaults on the debts loaded onto merger and takeover "target" companies by hedge funds, private equity funds, and banks. It's known as "leveraged" debt because it's issued on the assumption of looting the target. "Predators are extracting special dividends from prey to recoup their investment quickly, leaving these companies saddled with debt," said the report highlighted in a Dec. 15 London Daily Telegraph article by Ambrose Evans-Pritchard. The lending banks themselves, in turn, take risk fees which may be a couple percent of the total new debt; and the consulting banks, still more fees, which may be 0.5% of the total valuation of the takeover. Goldman Sachs led the world in this regard by making $2.1 billion in consulting fees on nearly 500 takeovers in 2006.
This S&P report, "Risk Outlook for 2007," followed one it issued on Oct. 25, on the same danger (see EIR, Nov. 3, 2006). That earlier report said that if the ballooning "leveraged debt" and "collateralized loan obligations" (CDO) market pits of the world blow out, banks in Europe and the United States will be left holding up to 40% of the bag of losses. Pension funds will hold a lot more. Large volumes of bank lending, it said, are going to burgeoning hedge funds and private equity funds which are buying more and more risky debt; and banks are advising pension funds to pour capital into these hedge funds as well. The funds are throwing this wave of capital into extremely leveraged debt (debt "justified" only by promises of dramatic future looting, cost cutting, and industrial shrinkage), thinking that they can "dump the risk" by selling that debt, as securities and financial derivatives contracts, to each other and to banks on the CDO markets. As the Financial Times expressed it, "the heat of investor demand is forging lending multiples and structures that would have seemed impossible just a couple of years ago," and the average debt "multiple" of such "capital investments" has grown to $6 borrowed for each $1 invested.
The Dec. 14 S&P report and conference call warned that: "Leveraged loans have exploded.... As the interest coverage becomes thinner, defaults are certain to increase.... Prudent financial policies are being discarded. The average purchase-price for European LBOs in the three months to November hit a record high level of 9.4 times earnings." Most of this purchase money is being borrowed, and S&P points to disturbing signs, including "a trend toward deals that are not even rated for credit risk.... The big question is what happens [to this debt] in a downturn," now underway, the report warns.
The new round of ongoing attempted takeovers in the airline industry, for exampleUSAir taking over Delta, United and Continental merging, AirTran taking over Midwestare new attacks on airlines already drastically shrunk and looted. Carriers that employed 420,000 workers in September 2001, employed 264,000 five years later, at more than a 25% cut in wages; their fleet of jets had shrunk by 12%.
On Dec. 13, Rep. James Oberstar (D-Minn.), who will chair the House Transportation and Infrastructure Committee, demanded that the Justice Department stop the USAir-Delta takeover; if not, he said, he'd start hearings to block such mergers.
Rapidly Worsening Financial Cancer
New York financial community sources report that, of the 30-40,000 corporate mergers and acquisitions (M&As) worldwide this year, only perhaps 1,000 have been "leveraged" takeovers (premised on placing large amounts of new debt upon the target firm in the takeover), but these account for more than half the market value and most of the debt. About half of these involve hostile leveraged takeovers and/or attempts, which bids often involve very large amounts of new debt, and "valuing" of the target company at 20-40% above its current market value. M&As in general are now the main driver for the stock market, led by the large amounts of money to be made in playing the leveraged takeovers. Investment banks and lending banks are making very large risk fees, up to 2.5% of the whole takeover loan. For hedge funds, the takeovers are more profitable than their derivatives-based strategies, which are getting harder to work.
The buyout firms' strategy in leveraged takeovers now, is to try to borrow as much as possible of the takeover price, and use the extracted cash flow of the target company, or the sale of its assets, for repayment.
Some very recent examples:
- An example of the new leveraged-debt extreme is the current attempt on India's (Hong Kong-owned) Hutchinson Essar communications firm, by Blackstone Group and Reliance Group (this is one of several competing bids circling around this target company. The $15 billion takeover price will be borrowed in its entirety from Citigroup and UBS-AG, if this takeover goes through.
- Qantas Airways takeover by the pirates of Macquarie Bank, Ltd. and Texas Pacific Group involves $9 billion in new debt, 15 times Qantas' earnings. This is the most controversial of the takeovers of 2006; Qantas, a state company until 1995, essentially Australia's only carrier, and one of the world's best-run airlines, is suddenly pulled down like Persephone into the Hades of private-equity debt speculation. "This deal is all about debt," one banker told the Sydney Herald. "The deal will only work if the consortium [Airline Partners Australia, so-called] can extract a 20% internal rate of return for 5-10 years. Otherwise, watch out for default. Qantas' debt will rise from $3.7 billion to $12.5 billion; annual interest will rise from $158 million to $715 million; the Australian government warned Dec. 18 that Qantas' debt will be junk-rated, and the government will not bail it out in future."
- Express Scripts' hostile takeover of Caremark Rxa merger of two of the biggest "pharmacy benefit managers" of the HMO jungleinvolves $14 billion in new debt, which is nine times the annual earnings of the combined target company. Caremark Rx debt may be downgraded to junk as a result.
- Apollo Management Group's takeover of Realogy Corp.which owns Century 21 and Coldwell Banker real estate companiesinvolves $7 billion in new borrowings from JP Morgan Chase and Credit Suisse. Realogy's debt was immediately downgraded to junk on Dec. 19, and the cost of insuring its debt against default leaped up, from 0.6% to 3% of the debt.
- USAir's attempted takeover of Delta will leave Delta with an immense $23 billion in debt, as opposed to the $10 billion debt it would have otherwise. This $13 billion in new debt is more than 25 times earnings, when last Delta had any earnings, in 2003. According to Delta's reorganization bankruptcy filing Dec. 19, which opposes the takeover, it would lose 10,000 jobs, 180 aircraft, and a 10% shrinkage of the combined airline. And absurdly, $4-6 billion of the new debt is to be floated simply to pay off unsecured Delta debt, which is now frozen in bankruptcy.
- The Freeport McMoRan Mining takeover of Phelps Dodge loads $15 billion in debt on the combination of two corporations which had no net debt; and produces a combined junk-rated company from two companies whose bonds were each AA-rated.
- The Harrah's casino takeover by private equity firms Apollo Management and Texas Pacific involves $10.4 billion in new debt, doubling Harrah's total debt to eight times its gross profits, or more than 30 times its annual earnings.