Evolution of Leveraged Buyouts: A New Era or Back to Square One?
A leveraged buyout (LBO) is a method of acquiring a company where the deal is financed by a combination of equity and debt and the debt is secured against the assets and cash flows of the target company. It is a sub-set of syndicated loans and is evolving as a financial tool to structure deals and maximize profits. Since leverage is an essential component of LBOs and the same is repaid by cash flows and assets of the target company, companies with relatively lower levels of debt, large asset pools and stable cash flows make the best targets for LBO.
An LBO strategy plays a critical role in financing speculative grade borrowers and can be used to achieve various purposes such as to convert a public company into a private company, to buy out a competitor or to improve the health of a company. It is an efficient method of acquisition without investing much capital and deriving good returns on equity and tax benefits. However, in many situations, an LBO makes the business over-leveraged and leaves the business in distress. Historical evidence suggests that leveraged structures are more likely to become distressed than non-leveraged structures. This article discusses the evolution of LBOs in the US market, especially in the last decade.
Until the Financial Crisis
The first LBO wave started in early 1980s with high yield bonds invented by Michael Milken (commonly called ‘junk bonds’) being an essential source of financing. However, excess speculation and loosely drafted covenants led to overpriced deals that soon resulted in the unfortunate crashing of the high yield bond market. Even the largest LBO deal of the time i.e. KKR-RJR Nabisco resulted in a series of losses. Towards early 1990s, leveraged financing was started to be seen as a highly risky acquisition strategy that leaves little scope for liquidity issues lest the business becomes distressed.
The 1990s were focused on economic recovery and revision of LBO structures with a comparable equity and debt amounts (almost 50/50 as opposed to 30/70 earlier). The next boom, also known as "the age of mega-buyouts," arrived in the 2000s with extensive expansion of the private equity deals involving large institutional investors. Several other factors like reduced regulatory costs and shareholder scrutiny, lower tax obligations etc. also contributed to extensive growth of LBOs during this time. However, this boom was also short lived due to massive downturn in the economy caused by the global financial crisis in 2008. Many mega buyouts such as TXU, buyout of Harrah’s Entertainment (now known as Caesars Entertainment), Energy Future Holdings etc. collapsed and resulted in Chapter 11 bankruptcy filings.
The Last Decade
The last decade saw the economy healing from the financial crisis. The tremors of failure of asset backed securitization market were still felt early in the decade. In December 2010, the US government approved a rescue package worth USD 700 Billion in order to streamline the financial system of the country. The banks and financial institutions also kept the interest rates at an all-time low and invested in buying government and corporate bonds in order to increase the capital available for investments and acquisition financing. The continued low interest rates over the years increased liquidity in the market while the borrowers relied extensively on cheap loans.
This decade is also marked by covenant-lite loans. Leveraged loans were beginning to be structured to include "incurrence covenants" rather than "maintenance covenants," lenient rather than restrictive repayment terms that allowed payment of dividends despite deferred repayment installments and were borrower friendly overall. However, this resulted in offering little protection to the lenders and contributed in increasing the leveraged lending volume further. In 2012-13, leveraged loans achieved new highs, soaring as high as USD 605 billion in new issuance activity topping the pre-Lehman record of USD 537 billion. In United States, leverage lending volume during these years nearly doubled from pre-crisis levels. The average debt to EBITDA ratio for highly leveraged loans hit 7.2x which was the highest since 8.1x in 2008. Acquisition of PetSmart in 2013, buyout of software firm Veritas by Carlyle group in 2015 are some of the highlight LBO deals of early 2010s.
In response to the increasing volume of leveraged loans and failure of many mega-buyouts during the financial crisis, the Federal regulators issued the Interagency Guidelines on Leveraged Lending (Guidelines) in March 2013. The Guidelines are a form of prudential regulations and were aimed to regulate systemic risks identified in leveraged lending. The Guidelines provide for a robust risk management framework to be implemented by financial institutions including an adequate review and monitoring system.
In 2014, further clarifications were provided to the Guidelines with respect to excessive leverage (that calls for additional scrutiny), repayment capacity (basis cash flows, growth prospects and security created) and covenant structure of the loan agreement (which can be covenant-lite as long as adequate mitigation factors are present). While the Federal Reserve endeavored to keep the interest rates low; the bittersweet experience with LBOs in the past coupled with Guidelines led the private equity investors to not only focus on lower interest rates but also on increasing the cash flow generation and coverage ratios of the target companies. In 2015, another further clarification to the Guidelines provided that any leveraged loan with debt to EBITDA ratio in excess of 6x raises concerns and requires additional scrutiny. This led to small scale leveraged deals to rebound easily with time, while the sophisticated mega deals were scrutinized under the revised regulatory framework.
The traditional lending institutions lent cautiously hereafter, whereas the unregulated non-banks like asset managers that were not covered under the Guidelines, continued to provide highly risky loans. A clear emergence of shadow banking within leveraged lending can be traced to the red flags highlighted in 2015 clarifications. Overtime, lending base shifted to a diverse set of investors such as investment funds, pension funds, insurance companies etc. The December 2019 report by Financial Stability Board states that there has been a significant increase in the role of non-banking financing institutions in leveraged lending because of little regulation on such non-banks, even though traditional lending institutions still have the largest exposure. While this allows for risk sharing amongst a set of diverse lenders, it has also made leveraged loans even more complex and opaque than before. Additionally, collateralized loan obligations (CLOs) became highly popular in the secondary market for leveraged lending and were used to fill the financing gap left by highly regulated traditional banks.
In subsequent years, the LBO market evolved further as the acceptable market practices under the Guidelines became clearer. However, in 2017, the enforceability of the Guidelines was called into question since it was not subjected to a 60-day review period by the Congress (required in the Guidelines). Given the confusion, some lenders engaged in structuring highly leveraged deals that were equal to or beyond the prescribed 6x Debt to EBITDA ratio. For example – LBO of CCC Information Services was leveraged at 7.5-8.0x EBITDA. Several LBOs crossed the 6x leverage mark and went as high as 8x-10x. A slowdown in the deals was noticed due to market downturn in 2018. Even still, CLO issuance expanded continuously and an increase in software company LBOs was also noticed.
Today the leveraged market resembles the 2007-08 market in many respects. The volume of leveraged loans has more than doubled; leverage levels are higher than before the crisis; refinancing risks have increased since 2017; non-banks are the most aggressive lenders similar to the subprime lenders and CLO issuance has been increasing significantly, matching up to mortgage backed securities in 2008. But most importantly, mega deals are making a speedy return to the market.
At present, the proposed leveraged buyout of Wallgreens Boots Alliance by the private equity giant KKR is the talk of the town. The deal is anticipated to be the biggest leverage buyout in the history of United States; however, it is facing trouble obtaining sufficient financing and is yet to be finalized. Other than Wallgreens, acquisition of power solutions business of Johnson Controls International by Brookfield Asset Management also made news for being a large-scale all-cash deal. Prior to this, the Blackstone – Refinitiv deal made an impression by financing two thirds of the buyout through debt.
LBOs in 2018 and 2019 are reflective of how interest rates are still relatively low although comparatively higher; LBO loan structure continue to be covenant-lite and hence, the debt levels are constantly peaking. It is also indicative of increased direct lending by less-regulated non-banks and return of junk bonds with full fervor. The similarities of today’s leveraged lending market with the 2008 market are alarming for the regulators. It cannot be denied that the financial institutions today are better equipped to identify defaults early and absorb losses that may occur. Even still, it may be prudent to nip the problem in the bud by addressing the challenges of unregulated financial institutions and non-binding guidelines sooner rather than later.