Leveraged buyout activity has been strong and is getting stronger, giving portfolio managers headaches as they deal with changing credit profiles and investments that suddenly look different than what they thought they were getting. The most recent example is the $5.1 billion leveraged buyout of Neiman Marcus by Texas Pacific Group and Warburg Pincus. Last week Standard & Poor's said it will lower the ratings of the department store company as a direct result of the deterioration of the credit profile of Neiman following the LBO.
The billions of dollars of debt will lead to much greater leverage and a drop in cash flow, according to S&P credit analyst Gerald Hirschberg. When the acquisition closes sometime in October, S&P is expected to lower the corporate credit rating on Neiman from BBB to B+. Additionally, a recovery rating of 2 will be assigned to its new $1 billion term loan. A rating of B+ will be assigned to a new issue of $850 million in senior notes, and the company's existing $125 million of 7.125% senior notes will be lowered to B+ from BBB. A B- rating will be assigned to a $750 million issue in senior unsecured notes as well as to a $575 million in senior unsecured notes.
"It puts a lot of stress on bondholders," one portfolio manager said. "What with the downgrading of the bonds, selling them off and the depreciation that may occur. Finally, once the credit profile has changed, it can be absolutely brutal for investors to reinvest debt back into it. If the company has a good franchise name and it can be brought back, the bondholder has a chance to see some value once the restructuring has finished. But if it is a small company just being bought out through an LBO with little chance of showing a return value in the end, you should get out as soon as possible."
The game can be less risky for high-yield portfolio managers. Erik Takaha, high-yield portfolio manager at Franklin Templeton, noted that high-yield bonds can be helped by an LBO. "When investment grade companies get LBO'd, there is a lot of risk to the bonds outstanding; they tend to trade down," he said. "But LBOs can be a mixed bag."
For the third quarter there have been 104 buyouts worth $22.1 billion, according to Moody's Investors Service, which says this quarter is on track to be the busiest ever. Things are not expected to slowdown anytime soon. "As long as stocks remain down, we will continue to see LBO activity," Takaha said.
