Recent financial crises have been associated with over-complexity: excessive structuring and derivative exposure that masked the real risk that investors were exposed to. But many of the crises that have hit the capital markets over the last 50 years have been at least partly driven by one pretty straightforward part of corporate finance: the leveraged buyout.
If you over-lever a company on the basis of wildly ambitious revenue forecasts that do not come to pass, then that debt pile will tip the firm over. It isn’t rocket science, but it happens again and again and again.
Leveraged finance got its reputation for irrational exuberance from the $25 billion RJR Nabisco sale to KKR in 1989, immortalized in the book ‘Barbarians at the gate: the fall of RJR Nabisco,’ which was published shortly afterwards. It was the failure of another jumbo LBO later that year, however, that really demonstrated the impact that leveraged buyouts can have on the system when they go wrong.
In October 1989, the mooted $7.2 billion LBO of United Airlines Corp failed, precipitating a stock market crash to echo that of Black Monday in 1987. Euromoney covered the deal in-depth in its November 1989 issue, describing it as the “fiasco of the decade”.
Advisers Salomon and Lazard Frères had put together overly optimistic financial projections, while the loan arrangers, Citibank and Chase Manhattan, were over aggressive in taking a loan that no one else would touch, we wrote. This involved a $5.9 billion term loan and a $1.3 billion revolving credit that offered 1% over the Citibank base rate or 2% over Libor for eight years.
Looking for $4.2 billion of commitments, the two arranging banks only managed to raise $1.4 billion. The $25 billion RJR Nabisco sale to KKR, which had closed in February, had offered a six-year deal paying 1.5% over US prime or 2.5% over Libor and better fees. So the reception afforded to UAL should have taken few by surprise.
The impact that the failure of the deal had on the market demonstrated just how destabilizing jumbo LBOs can be. But 20 years later they were again at the heart of financial chaos. The $44 billion 2007 buyout of TXU Corp (subsequently renamed Energy Future Holdings) by KKR, TPG Group and Goldman Sachs Capital Partners was the largest in history. It also swiftly earned the title of the largest non-financial bankruptcy in US history when the firm collapsed just seven years later.
The buyout firms had paid a multiple of 8.5 times ebitda for the firm and loaded it with an unsustainable $40 billion combination of loans and high-yield bonds that it could never repay.
TXU was just one of a series of mid-2000s jumbo LBOs that had heaped cheap debt onto corporates that buckled under the burden when the financial crisis hit. KKR was also behind the 2007 $29 billion LBO of First Data Corp, a deal with an ebitda multiple of 14 times and a debt burden that the firm immediately struggled to cope with.
It is important to remember, however, the faith in the resilience of the credit markets that existed before 2007. Bubbles had persisted for years – such as the one in Japanese real estate – and many believed that things would be no different this time. In leveraged finance there is also an enduring code that the market will always have the ability to recover if things go wrong.
“I remember that I spent the first two years in leveraged finance working on restructurings [because of the S&L crisis],” Jean-François Astier, global head of capital markets at Barclays, tells Euromoney today. “That is what happens to leveraged finance bankers during down cycles.
“It is the best training anyone could ever get. I got to see very early in my career how things can go wrong when there is too much leverage. I also learned how the high-yield market recovers, it gaps out very quickly when things go wrong but also has a tendency to recover very quickly. By 1993 and 1994 returns were in the high 30s.”
These are skills that are invaluable across investment banking.
Credit markets generally and the leveraged finance market in particular had shown great resilience to previous shocks by the time 2007 came along. The credit markets were solid after the junking of General Motors and Ford in mid 2005, and the leveraged finance market barely blinked in 2006 when hedge fund Amaranth was forced into the re-sale of a couple of billion dollars’ worth of leveraged finance assets after having been brought low trading in natural gas futures. The market absorbed it all in two days with barely a shift in prices.
Even in June 2007 confidence in market liquidity overrode concerns about weakening structures. “High levels of secondary liquidity essentially underpin investors’ behaviour in the primary market,” explained Richard Howell, head of European leveraged finance at Lehman Brothers at the time. “If there is a credit that is below plan and is trading at 97 cents or 98c, the manager will invariably just sell it and take a moderate loss rather than rely on covenants to bring him to the negotiating table in a workout.”
Twenty years after the UAL LBO collapse, therefore, banks were still bringing deals on the basis of wildly optimistic business plans. The difference this time was this belief that the quality of loan underwriting didn’t matter because there was always someone to sell to.
“It’s the greater fool theory,” Edward Eyerman, managing director in leveraged finance at Fitch Ratings told Euromoney in November 2006. “You can see from the bank plans, many of these leveraged financings are not designed to go to term; they don’t show the debtor being de-levered and the debt repaid out of cash flow. Rather, the projections typically show revenue and margin expansion, irrespective of cyclicality, such that the net debt profile de-levers modestly in three to five years and the market assumes refinancing for the B and C tranches will be available. Consequently, everyone is just bridging to the next refinancing with the expectation that the required cash generation will be realized and the market will be as buoyant as it is currently.”
History shows how that strategy panned out. Leveraged finance froze along with everything else when the credit crisis hit in 2007, and many investors found that the secondary liquidity they had relied on was suddenly no longer there.
“By 2007, I was co-head of the global leveraged finance business, and we had a very large exposure – more than $50 billion of commitments,” recalls Jim Amine, chief executive of investment banking and capital markets at Credit Suisse. “We became cautious on the market and sold down lots of risk, whereas others were saying it was just a blip and we were making a big mistake by crystallizing losses. This allowed us to steer the firm through the crisis with minimal damage.”
Amine partially attributes this outcome to his long experience in the market.
“We all remembered the S&L crisis, but the market was very different then,” he says. “We knew that the ability to move risk would change and that our mark-to-market exposure was significant, so we did learn that if you have a large asset class that gets impaired, then the potential losses can be very substantial.
“I didn’t know for sure that we were right, but we made a call on the market. From the point of view of revenue and the outlook for the market, it would have been nice to have been wrong, so I was kind of conflicted on what I wanted to happen. But we made a market call, and only one other firm did the same.”
Today, multiples are again on the rise in leveraged finance and a decade of cheap money means that many have started to ask if history is about to repeat itself.
“I may be the longest-tenured person in this space who is still working,” says Amine.
“I think we have to be data driven and talk about a number of different things. We look at structure of deals, and it is true that leverage is higher, but the amount of equity is a much higher percentage of the capital structure too. Then look at adjusted earnings – banks are doing a better job of being more careful about adjustments to ebitda.
“Third, a lesson was that if you have five equity investors all doing the acquisition equally, this is not good governance structure if you need to make quick decisions. Most banks now prefer to focus on large deals with only one or two investors and decision makers.”
He is also more optimistic about market discipline.
“After the GFC lesson, the kind of conversations that senior people at the banks had with heads of private equity firms, saying: ‘Look we know you are taking risk and we will help if you get into trouble’, everyone realized that was inappropriate. So, we have detailed letters on terms and conditions today and a much clearer roadmap on how things will play out if there is a problem. Finally, the market for leveraged loans and high-yield bonds is deeper and there are more dedicated investors, which is all positive.”
The market is very different today than it was in 2007, but it is also far larger and the impact could thus be more severe if it again spins out of control. Many lessons have been learned, but as sponsors push both banks and now increasingly institutional and private debt investors for ever-more flexible, covenant-lite terms, it is important to remember that personalities matter when things go wrong.
Back in 1987, UAL’s chief financial officer, John Pope, stood accused of bullying his bankers into a finely priced deal and that he ended up paying a far higher one when the deal blew up.
“He is a pain in the neck,” one banker who knew Pope well at the time told Euromoney. “He’s one of those people that like to get a bank down on the ground and then put his foot on its throat.”