This May, when the board of Australian airline Qantas realized that the leveraged buyout bid for the company from Airline Partners Australia that it had recommended had failed to garner enough shareholder support to take the company private, recriminations were immediate. The chairwoman and one board director announced their early retirements and the regulatory authorities in Australia announced new measures to monitor the incentives for corporate insiders to support take-private bids.
Less headline-grabbing: the company announced that it would be reviewing its capital management policies. Moody’s got the hint, though. It put the airline’s Baa-1 long-term rating under review for possible downgrade. Shareholders caught on quickly too, bidding the stock up, even as the Macquarie and UBS backed vehicle’s offer collapsed, in the expectation that management would now execute the same plans under public ownership that it had been hatching to boost the value of the company in private.
Qantas is just one recent example. Will more and more public companies respond to the threat of private equity takeover by doing just what private equity companies do: reducing equity and increasing debt to lower the overall cost of capital and ramp up the stock value?
Private equity has become a game of simple financial engineering. Buy the assets for 10 cents on the dollar down and borrow the rest; wait six months; re-mortgage at 110% loan to value; take your equity out; move on to the next deal.
The push-back from investors in June came against deals and structures at the margin of leveraged finance. It is overdue. Euromoney talked to most of the leading debt arrangers last month and many reported that private equity sponsors had been suggesting deals so outrageous that even the firms paid to arrange the debt had been trying to talk their customers out of them and turning the work down.
But it doesn’t follow from such examples that there is anything inherently bad about financial engineering. Why are public companies still so attached to investment-grade credit ratings in an age when companies can extend their leverage at modest absolute rates, capture the tax advantage of interest payments, and cut their cost of capital, with no apparent threat of exclusion from the financing markets just because the ratings agencies assign them two Bs rather than three?
The leveraged loan market had been showing clear signs of excess. But this is not a repeat of the 1980s’ LBO boom when under-qualified investors bought junk bonds in the expectation of holding them to maturity and benefiting from the high coupons and were caught out when the issuers, which they barely understood, went bust. Credit fund managers today live off their ability to analyse credit, trade the markets and buy on the dips. Really, caveat emptor.
The managers of public companies that do not wish to take advantage of the abundance of low-cost capital deserve to have their suitability to manage questioned. And shareholders with no stomach for modern-day capital structures should indeed consider making way. All that will frustrate the private equity sponsors, today sitting on financial firepower, on a leveraged basis, of perhaps $1 trillion, is for their potential prey to cut out the middleman and financially re-engineer themselves.
And if the lower risk tolerance of leveraged finance now forces private equity owners/investors to actively overhaul and improve the operational efficiency of the companies they buy, so much the better.
