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Recap happy

Leveraged buyout shops are recapitalizing portfolio companies in a hurry. Will trouble -- and a new round of defaults -- follow?

In the first week of January, barely two months after a $4.35 billion buyout left it with $3.1 billion in debt, specialty chemicals maker Nalco Co. announced that it would sell another $450 million in high-yield bonds. The biggest surprise wasn't the timing but where the proceeds were going: not into Nalco's coffers but straight to the company's new shareholders -- buyout firms Apollo Management, Blackstone Group and Goldman Sachs Capital Partners, the principal investment division of Goldman Sachs & Co. -- in the form of a special dividend.

What was splendid news for the owners appeared less appealing to the company's bondholders. "In one move these guys cut the amount of skin they had in the game," gripes Harry Resis Jr., a veteran junk bond investor who now runs institutional and mutual fund assets for Henderson Global Investors and who had bought some of Nalco's bonds last September. "They didn't even have the grace to wait until the company reported its first quarter of earnings under the new regime."

Nalco's maneuver boosted its leverage from six times to 6.8 times earnings before interest, taxes, depreciation and amortization -- more than six is considered aggressive by many buyout investors. Moody's Investors Service assigned a junk bond rating of Caa2 to the new debt, concluding that "the new financing results in a significant deterioration in credit metrics" and voiced concern about the company's ability to make scheduled deferred interest payments beginning in 2009 when they become due. Standard & Poor's cut its rating on the company's existing debt to B+ from BB­, concerned that Nalco would no longer have the financial ability to make a strategic acquisition or to contemplate an initial public stock offering to raise capital.

"The company -- and the sponsors -- have no room to do anything but cut costs to the bone and improve the earnings," says S&P credit analyst Wesley Chinn, adding that he thinks the expanded debt burden would make Nalco an unattractive acquisition candidate. (The buyout firms involved in the transaction declined to comment on record; the company didn't return calls seeking comment.)

The Nalco financing is anything but an isolated case. Leveraged buyout shops, coming off of three years of awful returns and enticed by extraordinarily favorable credit markets, have rushed to embrace recapitalizations, using a novel twist on a tried-and-true method to monetize their investments quickly. Traditionally, buyout firms put together dividend-paying recaps like Nalco's three to five years after the original LBO -- and after the buyout firms had proven the company's ability to deliver strong earnings, cash flow and revenues in good times and bad. Now LBO firms, burned after waiting too long to exit deals in 2000 and 2001, are recapitalizing deals they negotiated only months earlier or using the recaps as a way to pull out all of their equity in an old deal that has gone stale. In a few cases, financial sponsors have come back to the market repeatedly.

"This is the most aggressive approach to recaps I have ever witnessed on the part of people in my business," says a partner at one buyout firm.

In November, less than two months after the $7.05 billion buyout of Dex Media -- the yellow pages division of Qwest Communications -- Dex issued $750 million of junk bonds to pay a dividend to LBO firms Carlyle Group and Welsh, Carson, Anderson & Stowe. In late January a second $250 million tranche of bonds was issued -- and a second dividend paid -- leaving the buyout firms with $600 million of the original $1.6 billion in equity they had invested in Dex four months previously. The Nalco and Dex deals, along with the June 2003 $715 million recap of Regal Cinemas, rank as the biggest of their kind to hit the market, but scarcely a week has passed in the last several months without a dividend-related recapitalization, investors say. Credit analysts calculate that between late September and mid-April, dozens of these refinancings allowed LBO firms to harvest as much as $10 billion from their portfolio companies in the form of dividends.

"There is a financing party going on here," says Chris Donnelly, director of Standard & Poor's Leveraged Commentary & Data.

For financial sponsors the logic of the deals is compelling, as is their rush to make them. The economy is gaining strength, corporate default rates continue to fall, interest rates are still hovering at close to 45-year lows, and bond and loan investors are hungry for yield -- all good news for deal making. With outright exit strategies like mergers and IPOs still scarce or time-consuming and thus risky in today's volatile stock market environment, LBO firms are jumping on recaps as a way to return cash to their increasingly impatient limited partners. Nalco's deal was done in just a few days, say people involved in the transaction, enabling the sponsors to return capital to their limited partners quickly without having to cut their ownership levels.

"The less equity you have on the table in a buyout, the greater your returns on that equity. It's simple mathematics," says one Nalco investor. "The market would have let us add even more leverage if we had wanted to do that."

Buyout firms are also looking to raise billions of dollars for new funds. Some, like the Texas Pacific Group Partners IV fund, have already closed. Many more firms are preparing to approach investors, including Bain Capital, Carlyle Group and Clayton, Dubilier & Rice, say limited partners. Before the funds can go out on the fund-raising circuit, say people familiar with the situation, they do whatever they can to make their current portfolio companies and their returns look as appealing as possible. Part of that process, they say, is maximizing returns for current investors on their existing funds, whether through strategic sales or by generating cash returns through debt-financed dividends.

The funds are under increasing pressure to generate, on a consistent basis, the 20 percent-plus returns investors demand. And those returns can't just be on paper: Limited partners learned after the tech crash how illusory impressive paper returns can become in a bear market when financial markets slam shut and prevent exits. This time, limited partners want buyout fund managers to squeeze cash out of their portfolio companies whenever possible -- and a buyout shop's ability to raise its next fund may hinge on its skill in monetizing its investments.

"People had the opportunity to get out of some deals before the bubble burst in 2000 and 2001, but they didn't," says Jonathan Weiss, head of the financial sponsor group at J.P. Morgan Chase & Co. "So they weren't going to miss out on the next bull market's opportunities by being slow to act."

Issuing bonds when rates are low makes sense, of course. But buyouts always skate on a delicate financial edge, and the worry among some market participants is that companies will become overloaded with debt and run into trouble should the economy stall or lose ground. The dividend deals "just increase the instability of the company by borrowing in order to take money out of it altogether for the owners, rather than borrowing to reinvest in the company and build it," says Roger King, an analyst at independent research firm CreditSights.

Yet even the recently renewed fears of incipient inflation and the threat of higher interest rates hasn't stopped the recap party. The return of inflation, after all, is a sign that the economy is heating up -- good news for analysts worried that the issuing companies might be hurt by a bad turn in the business cycle. As the bond market has become more anxious about the prospect of higher interest rates, some of the refinancing activity simply has shifted to the loan market. Says S&P's Donnelly: "The liquidity is still in strong supply, there's still a shortage of paper, and people are less worried about higher rates."

The mechanics of the recaps are straightforward. In some cases, the company reworks both its loan and debt structure, increasing the total amount of debt in the process. In other cases, like Nalco's, it simply issues new bonds. The underwriter is often the same firm that helped structure the original buyout or a bank involved in the original loan package (in Nalco's case, the sole underwriter was Goldman Sachs, one of the three shareholders). When the deal is completed, the company passes on all or part of the proceeds from the transaction to its shareholders in the form of a dividend.

In one February recap, restaurant chain Buffets raised $310 million in new bank loans, of which $22 million was used to pay a dividend to buyout firms Caxton-Iseman Capital, Northstar Capital and Sentinel Capital Partners. That brings the total cash that the sponsors have withdrawn from the company to $164 million, well north of the $121 million in equity they invested in the $643 million Buffets buyout in the fall of 2000. A junk bond deal that would have boosted that dividend to $114 million was put on hold in early February as buyers responded to the flood of new issues by balking at some whose terms were seen as more aggressive. The registration for the bonds remains on file with the Securities and Exchange Commission, however, meaning that a third recap -- and another dividend -- could be in the works.

The rationale for the deals is slightly more complex. In a leveraged buyout, "the higher the leverage, the better, all things being equal," says Don Phillips, chief executive of WestAM USA, the Chicago-based private equity arm of Germany's WestLB. A firm that has invested $50 million in a $300 million buyout and that later sells the company for $600 million will see a different -- and much larger -- return on equity than a firm that invests $100 million in the same transaction. From the start, a buyout firm's objective is to finance a deal using other people's money by issuing debt or borrowing from banks. When default levels are high or rising and capital is tight -- as happened between 2000 and 2003 -- lenders aren't willing to finance highly leveraged buyouts. But over the past six to nine months, their attitude has undergone a sea change: The average equity contribution to an LBO has fallen from 40 percent in 2001 to 36 percent in late April, the lowest since 1999, according to Standard & Poor's. LBO firms would be "nuts to miss the opportunity to get money off the table," says J.P. Morgan's Weiss.

Nalco's deal, however, was aggressive enough that it reminded some investors of the heyday of the LBO industry in the early 1990s. It started out with 18 percent of the capital in the form of equity, but the January dividend cut that to just above 10 percent. "We could have borrowed even more," bragged one participant in the transaction, pointing to the interest rate environment and the eagerness of junk bond investors to take above-average risks in search of above-average returns. "We get to de-risk our investment and get the leverage closer to where we would have liked to have it in the first place."

Indeed, "de-risking" or "monetizing" a portfolio are buzzwords on the lips of many buyout fund general partners these days. "I hear it all the time in presentations general partners make to investors: how this time around they are really focusing on slashing risk to themselves" and to the limited partners who invest in their funds, says Carla Haugen at Norwalk, Connecticut­based Rocaton Investment Advisors. To a buyout firm, "de-risking" means investing in industries they know well, maintaining a diversified portfolio and bringing on experienced operating partners to handle day-to-day management issues at portfolio companies. But it extends to limiting financial risk: General partners used to focus on maximizing their internal rates of return, now they're even more focused on harvesting what they can from their portfolio companies. "It's not just about making good investments but knowing how and when to exit or monetize" those holdings, says Franci Blassberg, a partner at New York law firm Debevoise & Plimpton and co-head of its private equity group. "The name of the game is overall returns: If folks can generate some initial cash return that is attractive and then supplement it later with further return, that is a pretty attractive package."

The allure of dividend recap deals goes beyond improving a buyout firm's return on equity. In many cases, LBO firms aren't able or willing to exit a deal -- while markets may be more receptive, executing a stock offering can take three months or more from beginning to end. (And not all LBO fund portfolio companies are suitable IPO candidates: Of the 103 IPOs completed in the past 12 months, only four were prior LBOs, according to Thomson Financial.)

In contrast, a recap can take as little as ten days from the time the banker and the LBO firm decide to forge ahead with the strategy -- and doesn't dilute the sponsor's equity stake in the company. In some cases, other options simply aren't available: The sponsors haven't yet been able to boost revenues, pay down debt or take other steps to make the portfolio company appealing to other equity investors. Bankers say that although it's simpler to recap a successful LBO, leverage can be added to an unproven or ho-hum deal as well in order to pay out a shareholder dividend. In late April, for instance, Golden Gate Capital and North Castle Partners announced a $650 million recap of Leiner Health Products. The original buyout was executed in 1997 in North Castle's first fund; the recap allows the firm to generate an annualized 17 percent rate of return on the deal for investors in that fund while using proceeds from its new fund to reinvest in Leiner, this time alongside Golden Gate Capital.

Private equity investors are eager to see buyout firms take an aggressive approach to pulling equity capital off the table. Their attitude, says Rocaton's Haugen, can be boiled down to the query, "What have you done for us lately?" Until last fall, she adds, the answer was, all too often, too little. LBO fund returns are only just returning to the black, and little capital has been returned to limited partners.

With buyout firms now tapping their limited partners for new capital, they are keen to do what it takes to keep those investors happy. Part of the recipe, Haugen says, is improving valuations of existing portfolio companies, something that is already happening as the economy strengthens. But "there has to be a balance between internal rates of return and cash returns" to limited partners, says William Price, a founding partner of Texas Pacific Group. Some limited partners, notably managers of endowments at big investors such as Harvard University, held blunt discussions with Blackstone on just this topic when it raised its $6.45 billion fund in 2002, say people familiar with the fundraising.

"One of the first five questions a limited partner asks is, 'What amount of the existing fund has been monetized?'" says Eric Karp, a managing director at Banc of America Securities. "Today absolute returns to LBO firms are in the 20 percent range, compared with the 30 percent range in the early 1990s. That puts more pressure on the general partners to do smaller financial engineering things to enhance those returns."

The emphasis on financial engineering as a source of returns is reminiscent of the 1980s, when buyout firms generated the bulk of their returns by restructuring corporate balance sheets. In the 1990s the focus shifted, with sponsors concentrating instead on companies' operations and seeking ways to boost revenues, market share and profit margins. Today's recaps, says William Crooks, a managing director at New York­based investment bank Morgan Joseph & Co., demand both sets of skills and show that the pendulum has swung back from an exclusive focus on operational improvements. LBO firms, he adds, have to be ready to seize any opportunities presented by the financial markets.

With their relationships with their own investors and their future fundraising ability at stake, therefore, it's little wonder that buyout firms of all kinds and sizes are reviewing their portfolios in search of suitable candidates for recaps, often in response to prodding by investment banks in search of deal flow. (Restructuring a loan can generate about 1.5 percentage points of the total amount in fees; fees on a junk bond issue can be double that, bankers say.) One partner at a major LBO firm admits he thinks the recap/dividend boom is "a little crazy" but that the pressure to do these deals is hard to resist. "We may end up doing a deal or two, sure," he concedes.

To avoid repeating the errors of the early 1990s, when debt-laden companies defaulted and filed for bankruptcy, the amount of debt added to balance sheets to finance a shareholder dividend has to be carefully calculated. This is where buyout firms part company with rating agencies and existing investors. "Whenever a market gets too hot, whenever capital is too available, deals get done that shouldn't be done," says Henderson Global's Resis. "There's at least a risk that we'll look back in a few years and realize we created a big problem for the whole market and for dozens of companies by allowing our greed for yield to get the better of our judgment."

Resis bought the Nalco bonds issued when Apollo, Blackstone and Goldman Sachs first completed their buyout of the company from French conglomerate Suez -- but balked at buying the new issue and is still fuming about the dividend deal. "The sponsors reward themselves with a dividend, and we got rewarded with a downgrade on our holdings." He is hanging on to the bonds, however, hoping that the wind will be at Nalco's back for the next few years. "The consequences of a bad decision by the sponsors for the company aren't going to be seen immediately," he notes. "It's going to take a while; we'll see how Nalco does when the economy isn't strengthening and when they start having to pay cash dividends on this new debt in five years."

In rating the new bonds, Moody's noted that Nalco will need to generate at least $100 million to $125 million of free cash flow in each of the next two years to avoid a ratings downgrade. For 2003, according to Nalco's latest earnings release, the company's cash flow after capital spending, business purchases and other investing activities totaled $84.9 million. Nalco's sponsors insist that even with the additional leverage, the company is more than able to fund its obligations.

The biggest risk facing LBO portfolio companies and their creditors, argues S&P's Donnelly, is that the less equity the buyout firms have at stake, the easier it is for them to walk away from a company when trouble hits. "The greater their remaining equity stake in the company, the greater interest they have in investing time, energy and money to turn it around rather than letting it collapse," he says. "If they have no remaining investment to protect because they've pulled out all the equity they put in, well, there's no investment to protect any more."

LBO general partners pooh-pooh Donnelly's concerns. They point out that if they get a reputation for overleveraging portfolio companies and then leaving them to their fate, they won't be able to execute new deals. Indeed, even as investors like Resis balk at putting capital into dividend deals like Nalco's, enough of his peers are willing to invest to keep the trend going, even if it slows down slightly while markets brace for higher interest rates. In that context the only thing that will stop the recap trend from being carried to excess is discipline on the part of the LBO firms, says Morgan Joseph's Crooks. "You can't keep on and on doing this with your portfolio company" without swapping short-term risk reduction for the LBO firm with an unacceptable risk to the portfolio company in the longer term. At some point, Crook argues, the market will shift to talking about the impact of all that new leverage on the portfolio companies.

"This is well within our comfort zone and the company's comfort zone," says one participant in the Nalco deal. "As long as we don't jeopardize the overall health and welfare of the company by forcing it to cut back on capital spending to fund its debt, then it's not a crisis. All we're doing is redeploying capital efficiently -- we're being smart capitalists."