Private-Equity Payout Debt Surges

By RYAN DEZEMBER and MATT WIRZ Private-equity firms are adding debt to companies they own to fund payouts to themselves at a record pace, as fears mount that the window for these deals will close if interest rates rise. So far this year, $47.4 billion of new loans and bonds have been sold by companies to pay dividends to the private-equity firms that own them, according to data provider S&P Capital IQ LCD. That is 62% more than the same period last year, which wound up being the biggest year on record, with $64.2 billion sold to fund private-equity payouts.

Michaels Stores increased the size of its bond offer to $800 million. Buyout firms acquire companies with a combination of cash and debt, which the acquired companies aim to pay back with earnings. In dividend deals, private-equity-owned companies add more debt so they can pay dividends to their owners. Ultimately, the payouts are distributed to the buyout firms' own investors, which include endowments, pension funds, wealthy families and the firms' executives. The added debt, known as a recapitalization, can increase companies' risk of default, according to a recent study by Moody's Investors Service. Dividend deals are like "taking out a home-equity loan and then using the money to go on vacation," said Ray Kennedy, a high-yield bond fund manager at Hotchkis & Wiley Capital Management LLC in Los Angeles, which he said generally tries to avoid dividend deals. "You didn't use the money to do anything productive in the house like redo a room; you just went out and spent the money." As dividend deals increase, many also are unusually risky lately, carrying low credit ratings and paying historically low interest rates to investors. "This is the leveraged-finance debt market that you can't quite kill," said Richard Farley, a lawyer with Paul Hastings LLP who represents banks in buyouts. The surge in dividend deals follows a bond-market slump in May and June when interest rates rose on Federal Reserve Chairman Ben Bernanke's comments about tapering the central bank's bond-buying program, which has kept rates low for years.

When the market bounced back last month, private-equity firms, including Blackstone Group LP, Bain Capital LLC and BC Partners Ltd., rushed new deals to market in anticipation that the window for the lucrative transactions might not remain open indefinitely. About 60% of all bonds private-equity-owned companies sold in July were used to pay dividends to shareholders, well above the 14% average this year, according to S&P data. Earlier this year, the private-equity owners of health-care-cost manager MultiPlan Inc. were considering a dividend deal when Mr. Bernanke's hints prompted debt investors to yank billions of dollars from the funds that buy such "junk" bonds. By mid-July, however, the flow of money had reversed, and billions were being pumped back into so-called high-yield bond funds. BC Partners and private-equity firm Silver Lake, which bought MultiPlan in 2010 from two other buyout shops for about $3.1 billion, including debt, noticed the shift and pounced, according to people familiar with the matter. The company had paid down some debt after its buyout. MultiPlan sold $750 million worth of "pay in kind toggle" or PIK togglebonds that are considered risky for investors because they allow the company to defer cash interest payments. Though the bonds received one of the lowest possible credit ratings, investors flocked to the

offering, agreeing to an 8.375% interest rate, lower than where similar deals have priced in the past. MultiPlan completed the deal in a day and will apply the proceeds toward an $838 million dividend. Days later, arts-and-crafts retailer Michaels Stores Inc. came to market with $700 million of its own PIK toggle bonds, with the aim of raising money for its owners, Blackstone and Bain. The offering met high demand, allowing the company to boost the size of the issue to $800 million, and investors agreed on a 7.5% interest rate. People familiar with the thinking of the retailer's owners said Michaels proved resilient through the financial crisis, and even after the $800 million in new debt is added to its books, the company's ratio of debt to earnings will be lower than it was immediately after its 2006 buyout. Still, the interest rate raised eyebrows. "A PIK toggle at 7.5% is a little crazy to me," said John Fraser, managing partner of 3i Debt Management U.S., which didn't invest in the deal. "It suggests that investors are getting a little ahead of their skis." The market has shown that it will go lower yet. Healthcare consultants IMS Health Inc. on Aug. 1 sold $750 million of 7.375% PIK toggle bonds to fund a payout to owners TPG, Canada Pension Plan Investment Board and Leonard Green & Partners LP. The deal follows an October transaction in which IMS issued new debt to pay its owners about $1.2 billion. Though IMS is boosting its debt to nearly seven times earnings before interest, taxes, depreciation and amortization, Moody's said in a research note last week that its anticipated free cash flow of about $150 million should give it "the ability, if not necessarily the inclination, to delever modestly." Overall this year, bonds sold to pay dividends have carried an average interest rate of 8.2%, down from about 9.8% the year before, according to S&P. Meanwhile, more than half of this year's dividend bond deals have been rated triple-C, the lowest credit rating for new bonds, compared with 11% in the same period last year, the ratings firm said. Buyout shops also are helping to fuel the appetite for dividend deals as they sit on huge piles of their own cash and pursue relatively few buyouts. Though low interest rates have recently enabled firms to finance multibillion-dollar buyouts at rates that compare to those available to home buyers, a monthslong run-up in stock prices has made acquisition targets more expensive, and the cheap money has fueled price-lifting bidding wars, executives say. Fewer buyouts mean fewer new junk bonds to help absorb some of the demand for high-yield investments, they say. Also, some investors are willing to buy PIK toggles and other risky bonds because they believe the companies selling them are likely to soon hold initial public offerings or be sold, given the strong IPO market. Such sales often trigger payment of the bonds at small premiums, investors say. Write to Ryan Dezember at ryan.dezember@wsj.com and Matt Wirz at matthieu.wirz@wsj.com