PE and Junk Bonds

7/29/2019 PE and Junk Bonds

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Private-Equity Payout Debt SurgesByRYAN 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 paydividends to the private-equity firms that own them, according to data provider S&P Capital IQLCD. That is 62% more than the same period last year, which wound up being the biggest year onrecord, 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 acquiredcompanies 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 thebuyout firms' own investors, which include endowments, pension funds, wealthy families and thefirms' executives.

The added debt, known as a recapitalization, can increase companies' risk of default, according toa recent study by Moody's Investors Service.

Dividend deals are like "taking out a home-equity loan and then using the money to go onvacation," said Ray Kennedy, a high-yield bond fund manager at Hotchkis & Wiley CapitalManagement LLC in Los Angeles, which he said generally tries to avoid dividend deals. "Youdidn'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 andpaying historically low interest rates to investors. "This is the leveraged-finance debt market thatyou can't quite kill," said Richard Farley, a lawyer with Paul Hastings LLP who represents banks inbuyouts.

The surge in dividend deals follows a bond-market slump in May and June when interest ratesrose on Federal Reserve Chairman Ben Bernanke's comments about tapering the central bank'sbond-buying program, which has kept rates low for years.
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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 windowfor the lucrative transactions might not remain open indefinitely.

About 60% of all bonds private-equity-owned companies sold in July were used to pay dividendsto 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. wereconsidering 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 hadreversed, 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 otherbuyout shops for about $3.1 billion, including debt, noticed the shift and pounced, according topeople 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 areconsidered 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


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offering, agreeing to an 8.375% interest rate, lower than where similar deals have priced in thepast.

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 ownPIK toggle bonds, with the aim of raising money for its owners, Blackstone and Bain. The offeringmet 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 thefinancial crisis, and even after the $800 million in new debt is added to its books, the company'sratio 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 DebtManagement U.S., which didn't invest in the deal. "It suggests that investors are getting a littleahead of their skis."

The market has shown that it will go lower yet. Healthcare consultants IMS Health Inc. on Aug. 1sold $750 million of 7.375% PIK toggle bonds to fund a payout to owners TPG, Canada PensionPlan 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 freecash flow of about $150 million should give it "the ability, if not necessarily the inclination, todelever modestly."

Overall this year, bonds sold to pay dividends have carried an average interest rate of 8.2%, downfrom about 9.8% the year before, according to S&P. Meanwhile, more than half of this year'sdividend bond deals have been rated triple-C, the lowest credit rating for new bonds, comparedwith 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 oftheir own cash and pursue relatively few buyouts.

Though low interest rates have recently enabled firms to finance multibillion-dollar buyouts at ratesthat 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-yieldinvestments, they say.

Also, some investors are willing to buy PIK toggles and other risky bonds because they believe thecompanies selling them are likely to soon hold initial public offerings or be sold, given the strongIPO market. Such sales often trigger payment of the bonds at small premiums, investors say.

Write to Ryan Dezember [email protected] Matt Wirz [email protected]
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PE and Junk Bonds

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