LBOs
Jumping on the
bandwagon
A wave of leveraged buyouts is on the horizon, but while private equity firms, investment banks
and high-yield investors are rubbing their hands at the prospect of a raft of new opportunities,
investment-grade bondholders fear they might end up paying the price. Lisa Cooper reports.
W
ith share prices struggling, interest rates
at rock bottom and companies looking
to spin off non-core businesses, it was
only a matter of time before the leveraged buyout
(LBO) returned in force.
Observers say the situation now is reminiscent of
the late 1980s when LBOs – the tactic of using bor-
rowed money secured against a target company’s
assets to launch a takeover – exploded in the US.
David Aberle, credit analyst at Baring Asset Manage-
ment in Boston, says: “Equity valuations now look
very similar to the values that led to the first round
of LBO activity in the US in the late 1980s.”
The trend started emerging over the summer: in
August, Rodinheights bought Irish property com-
pany, Green Property, for more than €1 billion in a
management buyout (different from an LBO in that
the target firm’s management are involved in the
buyout). The deal was backed with private equity
from Merrill Lynch and Bank of Scotland. Another
Irish company, packaging manufacturer Jefferson
Smurfit, was acquired in late September for €4.5 bil-
lion by Madison Dearborn Capital Partners
(MDCP) Acquisitions, an affiliate of the Chicago-
based private equity firm Madison Dearborn.
Other deals are in the pipeline. The private
equity firms Kohlberg Kravis Roberts (KKR) and
Wendel Investissement are buying Legrand, a
French electrical equipment manufacturer, for €5
billion from parent company Schneider Electric.
And bankers are working on LBO deals for airline
catering company Gate Gourmet of Switzerland,
Germany’s Haarmann & Reimer, which produces
flavours and fragrances, and UK food distribution
company Brake Brothers.
This bustle of activity is not only welcome news
for the mergers and acquisitions departments of
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investment banks, which have struggled to justify
themselves since the technology boom turned sour,
but will also provide a much-needed boost to the
European high-yield market. Analysts expect that
deals totalling as much as €4.2 billion might come
to the euro and sterling high-yield markets to
finance US and European LBOs. In the first half of
2002 only €1.9 billion was raised in the European
high-yield market and only £250 million in the ster-
ling market. Elder, JPMorgan: credit
In fact, the LBO debt supply in September is so protection now greater
large that investment bankers are said to be trying to
squeeze roadshows around one another, hoping that
deals do not get overlooked with so many vying for
investor attention. As Baring’s Aberle says: “The cal-
endar is the busiest I’ve seen it for years.”
Investors are also encouraged that many of the
buyouts involve large private equity firms such as
KKR, which was involved in the largest-ever LBO,
the $25 billion acquisition of tobacco firm RJR
Nabisco in 1989. “It is always good to see sponsors
with deep pockets in case the deal goes awry and
needs supporting,” says one high-yield fund man-
ager in London.
And more is expected. “There are still plenty of
deals to be done on the lower end of the size spec-
trum, such as small regional companies with a very
focused business and a good asset base,” says Marino
Valensise, head of credit at Baring Asset Management.
But as the saying goes, every silver lining has a
cloud, so while high-yield investors welcome the
new supply, not everyone in the investment commu-
nity is happy about a resurgence in LBO activity.
Holders of any bonds that the company may have
issued in the past may see their investments dwindle
as the company takes on substantial amounts of new
debt to finance the buyout.
credit OCTOBER 2002 41

Of the firms with recent or imminent LBOs, both
Jefferson Smurfit and Legrand have bonds outstand-
ing. Jefferson Smurfit’s financing arm, Smurfit Fund-
ing, has a $250 million bond due 2005 and a $350
million bond due 2025. These will both become sub-
ordinate to the new debt. As a result Standard &
Poor’s downgraded the company from BBB+ to BB+
at the start of September and left it on watch nega-
tive. Moody’s has kept the company on Baa2.
“The sterling market is dominated by a relatively
small group of investors who can make or break
a transaction”
● Frances Hutchinson, HSBC
Legrand has a $400 million 30-year Yankee bond
issued in 1995. Standard & Poor’s currently rates the
notes A- and Moody’s Baa1, but both ratings are on
review for possible downgrade. Xavier Buffon, S&P’s
Legrand analyst, says that if the takeover is successful
“a multi-notch downgrade is likely”, though he will
not speculate on where the rating will end up.
The acquisition of Legrand, due to close late this
year, will use €2 billion of equity, €2.2 billion of
senior bank debt and a €600 million high-yield
bond issue. Howard Sharp, director, leveraged syn-
dications at Royal Bank of Scotland, one of the
banks involved in the deal, estimates that the bonds
will be rated in the single-B range, Therefore any
outstanding bonds will be downgraded to the same
level. And while the outstanding bonds include a
42 credit OCTOBER 2002
Illustration: David Lyttleton
change of control provision, this only takes effect in
the event of a hostile takeover. With the manage-
ment of parent company Schneider backing the deal,
it does not qualify as hostile.
Sharp says: “The bonds are non-callable, so we
don’t have the option to refinance them.” But he
admits that even if bondholders asked the company
to redeem the debt, it would be unlikely to do so
since it is not obliged to.
Some investors are so incensed by the way exist-
ing bondholders can be treated when an LBO takes
place that they are taking drastic action. “If any bank
issues bonds in connection with an LBO and we
already hold bonds in that company, we will ques-
tion our trading levels with that bank,” says Bernard
Hunter, director of fixed income at Merrill Lynch
Investment Managers. “It’s a message we’ve made
quite clear to our own counterparties and I know
others have too,”
Another senior London-based credit research
analyst agrees: “Our high-yield investors would
invest in new issues from leveraged buyouts, but not
if this would hurt existing bondholders; just as I
wouldn’t buy a stolen Rolex even though it wasn’t
stolen from me.”
He continues: “It should be bad business prac-
tice to advise companies on how they can shaft
bondholders. If they are fair and reasonable with
us, then we’ll be fair and reasonable with them.”
Frances Hutchinson, head of European credit
research at HSBC, says this policy can work. “The ster-
ling market is dominated by a relatively small group of
investors who can make or break a transaction,” she

says. “This allows institutional investors to have more
influence on the terms and conditions of specific deals.”
A recent example of the influence investors can
wield in the UK is Green Property, which issued £150
million of investment-grade, fixed-rate bonds in
December 2001. As a result of this summer’s LBO, the
bonds were downgraded to sub-investment grade.
However in this instance, existing investors should
not find themselves out of pocket. When the bonds
were launched in 2001 bond investors demanded
comprehensive covenants because property compa-
nies had become frequent targets for takeovers and a
previous attempt was made to buy out the company
in 2000. The implementation of change of control
covenants – which state that in the event of a
takeover resulting in a downgrade of bonds below a
specified level, the debt must be bought back and
new bonds issued – means the debt is in the process
of being redeemed.
Green Property’s bond issue was joint-led by
HSBC. HSBC’s Hutchinson says: “We have long been
advocates of appropriate use of covenants, in particular
change of control provisions.” She adds: “When we’re
advising a potential borrower, it’s important that the
debt is structured and priced appropriately. Issuers
want the most efficient source of funding, while
investors want the best deal. In the long run, it’s bad
for the investment banks if deals are not structured
properly or are detrimental to one group of investors.
It leaves a bad taste in investors’ mouths.”
One of the most notorious examples of existing
bondholders getting a raw deal in a buyout was
Nomura Principal Finance’s takeover of electrical
appliance manufacturer Thorn for £1 billion in 1998
– the biggest LBO that year. In that instance, the
existing senior unsecured debt was made subordi-
nate to all new debt. Bondholders were left with
junk bonds that effectively functioned as venture
capital if the firm did badly, but would not benefit
from the company doing well. “Although they did-
n’t break any laws or the letter of the bond docu-
mentation, it was a clear violation of the spirit of the
bond covenants. You could call it daylight robbery,”
says Bergqwist.
Even the rumour of an LBO is enough to set a
company’s bond spreads widening. For example, an
article in a Sunday newspaper in 1998 hinted that a
private equity firm was eyeing up the UK leisure and
entertainment group Rank. The price of the com-
pany’s bonds dropped from 102 to 88 and their liq-
uidity dried up.
But Fergus Elder, managing director and co-head
of loan capital markets at JPMorgan, which is involved
in the Haarmann & Reimer and Brake Brothers LBOs
this year, says times are different now. He believes it is
unlikely that extreme examples like the Thorn deal will
occur again. “I’d be very surprised to see something
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LBOs
like that happen now, as we’re in an era of greater
credit protection. Most buyers would want to revamp
the financing anyway and take out the senior bond-
holders. You really don’t want a recalcitrant bond
group in an LBO, as there will always be some issue
you need to tinker with, which will need both bank
and bondholder approval.”
Despite the examples outlined above, it must be
stated that not all LBOs are evil. In Europe, only a
small minority of companies undergoing an LBO
actually have bonds outstanding. And when they do,
this debt is not necessarily structurally subordinated.
In most instances, existing bondholders will be
bought out.
And there are plenty of willing buyers of LBO debt
in the European high-yield market, where banks and
hedge funds are vying with fund managers. In the case
of LBO financing, investors need to assess the type of
business, the quality of the equity sponsor and the man-
agement plan. As most bond launches originating from
LBOs are, by their very nature, large issues, any high-
yield investor would take an interest in them. For exam-
“You really don’t want a recalcitrant bond group in
an LBO, as there will always be some issue you need
to tinker with”
● Fergus Elder, JPMorgan
ple, around €1 billion of notes were offered in Septem-
ber via Deutsche Bank and Merrill Lynch as part of the
Jefferson Smurfit LBO. “No manager of a European
high-yield portfolio can afford not to look at this. It is a
big deal and will make up a sizeable portion of their
index,” says Baring’s Valensise.
However other investors insist that, unlike invest-
ment-grade debt, very few high-yield funds are actu-
ally managed against an index, so investment compa-
nies wanting to take a stand against what they see as
unethical behaviour are free to do so. By refusing to
participate in a deal in which existing bondholders will
be penalised, investors hope they will be able to
encourage better market practice for the future.
A company’s attitude to its existing bondholders
may depend on whether it is likely to need continued
access to the bond market. If the firm needs to issue
more bonds in future, it must be cautious in its treat-
ment of existing investors so that they won’t refuse to
participate in any forthcoming issues.
As the Green Property example shows, covenants
can help bondholders assert their rights. As well as the
change of control clause, a second provision that can
be beneficial is a negative pledge. This should ensure
that senior unsecured debt remains senior and unse-
cured, and is not subordinated by assets being
pledged to raise further debt finance. ■
credit OCTOBER 2002 43