Leveraged finance: Firms fend off pressure to releverage – for now


Kathryn Tully
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Few companies are pursuing leveraged share buybacks, but pressure from activist investors is putting the issue back on the agenda and there could be a lot more deals in the next 12 months.

The owners of Phelps Dodge copper mining company are under pressure to return money to investors
At a time when hedge funds are putting increasing pressure on companies to accelerate share buybacks, and private equity firms are using cheap debt to go after bigger corporate buyout targets than ever before, it’s tempting to conclude that companies are being forced to increase leverage in order to return cash to shareholders before someone else decides to do it for them. However, while leveraged share buybacks could become a lot more common in 12 months’ time, commentators say there’s little evidence to suggest that the technique is taking off yet.


Although the number of companies buying back shares using cash on the balance sheet is increasing, analysts say, there have only been a few cases where companies have increased debt specifically to buy back shares. In February, biotech company Amgen issued one $2.5 billion 2011 convertible bond and one $2.5 billion 2013 convertible. Some $3 billion of the proceeds were to be used buying back common shares and most of the rest was used to buy protection against potential future dilution to Amgen stock should the notes be converted. And in March, Affiliated Computer closed a new seven-year $800 million syndicated loan, lead arranged by Citigroup, to buy back $464 million-worth of the company’s common shares through a Dutch auction.

But there have certainly been cases where activist investors have pressured companies to do this. In an extreme example, one of US copper producer Phelps Dodge’s major shareholders, Atticus Capital, demanded in February that if the company did not increase leverage to return cash to shareholders, it would work with potential acquirers to ensure that the company was sold. “Some companies are just under pressure from shareholders to use the cash on their balance sheets but there are certainly some situations where they are being asked to take on incremental debt,” says Marc Zenner, global head of the financial strategy group at Citigroup in New York.


There have been more efforts by activists to get companies to releverage their balance sheets to pay out shareholders then there have been successes. At the beginning of April, Phelps Dodge announced that it was increasing its share buyback programme to $2 billion from a planned $1.5 billion, including a special dividend of $2 a share and an increase of the regular stock dividend to 80c per share.

However, chairman and CEO Steven Whistler called the demand to add debt to purchase additional shares “a reckless bet” and said that “the company intends to maintain a solid investment grade credit rating through the copper cycle, keep an appropriate debt-to-capitalization ratio and retain sufficient cash balances to maintain Phelps Dodge’s financial flexibility and to ensure the appropriate funding of its growth and asset improvement projects.” This is despite the fact that Phelps Dodge’s gross debt to ebitda is just 0.2 times, according to research firm Gimme Credit.

To date, long-term flexibility to make acquisitions, particularly in cyclical industries such as metals, is winning out over the potential weighted average cost of capital and earnings accretion gains associated with leveraged buybacks.

However, that could be set to change, according to John Tierney, quantitative credit strategy analyst at Deutsche Bank in New York, unless long rates go up significantly. “There’s not much evidence yet of companies issuing debt with the specific intention of buying back shares, but I don’t think we’re going to get through this year without seeing a step-up in this sort of activity,” he says. He says that’s partly because the strategy of companies using free cash to buy back shares, which is definitely increasing in popularity, doesn’t seem to be working. “When this happens, the market just tends to mark down a company’s P/E ratio accordingly,” Tierney says.

Citigroup’s Zenner agrees that this issue has been brought back to centre stage as a result of hedge fund pressure and that leveraged buybacks are even being considered by companies that are not widely held by hedge funds. "Only a few companies have issued new debt to buy back shares to date, but hundreds of companies are looking at it and it’s under discussion a lot more now than it was 12 months ago."