DONE DEALS - Realogy Meets Reality

The bonds backing a real estate brokerage’s LBO are falling fast in the secondary market. That could make already-spooked investors even less likely to support new buyouts.

INCE THE CREDIT MARKETS SEIZED UP IN August, Wall Street has worried itself sick over the question of whether banks will be able to clear a glut of some $300 billion in leveraged-buyout debt they have yet to sell to investors. The backlog is slowly beginning to shrink: Witness last month’s sale of $9.4 billion in risky loans supporting the LBO of First Data Corp. Now the question is: What happens when the riskiest buyout debt issued during the binge of the past few years starts to go sour?

Consider the more than $3 billion in bonds that residential real estate broker Realogy Corp. sold in April to finance its $6.6 billion acquisition by Apollo Management. Investors who bought the bonds were already concerned about the deteriorating housing market and pushed the offering prices on the multipart issue below par, to 98 and 99 cents. But Realogy, like so many other risky borrowers, still managed to win friendly terms: A $550 million portion of the offering, for instance, gives the company the option of making interest payments in kind -- by issuing more debt -- rather than in cash. Such payment-in-kind “toggles” are a fixture of much of the buyout debt issued in the past year, including giant offerings for health care services provider HCA and Freescale Semiconductor.

But what happens when the notes actually toggle? Realogy, the parent company of national real estate chain Century 21, may be the first test case, say nervous bond investors. In late September, even as debt markets rallied in response to the Federal Reserve Board’s cutting short-term interest rates, Realogy’s two senior seven-year issues -- $1.7 billion in 10.5 percent notes and the $550 million in 11 percent PIK notes -- traded for about 86 cents on the dollar. Investors clearly fretted about the impact of deepening housing woes; another tranche that’s less senior in Realogy’s capital structure had fallen to 76. On paper, the moves wiped out more than $400 million in just five months.

The subordinated tranche is falling faster because hedge funds are selling these bonds short. The strategy is a bet that Realogy will soon elect to pay interest on the PIK notes with additional debt instead of cash; the resulting new debt would be senior to the subordinated notes, whose value would thus decline.

Another worry for bondholders is the prospect of the company’s adding debt when it can’t afford its existing obligations. Realogy does not disclose financial information to the public; its bonds were issued in a private placement. But according to one analyst who has access to its most recent quarterly financials, even if it meets its own earnings targets for fiscal year 2007, which ends in February, it may have a cash flow shortfall of nearly $100 million. That, reasons the analyst, who declines to be identified because of the sensitivity of the topic, could mean Realogy would need to dip into its $125 million cash reserves or the $740 million available on its $1 billion revolving loan facility to cover operating and interest expenses.

A Realogy spokesman disputes the notion that the company will need to tap reserves or bank lines, but declines to elaborate on the company’s finances. Apollo won’t discuss the deal. But Realogy told investors on August 15 that it expected to produce $754 million in operating earnings for the third quarter, reaffirming previous guidance despite further weakening in the housing market.

So far most of the PIK notes that were sold during the LBO boom have held up well and are trading in the low 90s. But Realogy’s troubles show what could be in store for other issues. If the company’s woes deepen or the pain spreads to other industries, investors could shy from new buyouts. Peter Ehret, a high-yield portfolio manager at AIM Investments, puts it bluntly: “I need a strong incentive to look at the new-issue market when I can pick up slightly older issues in the secondary market at a 10 percent discount.”

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