Just a few weeks ago, the deal looked like a cinch. Cadbury Schweppes had put
its American soft-drinks operation up for sale and buyers were clamouring to
make an offer.
Cadbury’s decision to sell the business had been prompted by the intervention
four months ago of an activist investor. But it was an idea that Cadbury
liked anyway. And the operation, maker of Snapple and 7-Up, was a perfect
private-equity target – a large, established company generating cash by the
bucketful. Analysts speculated excitedly that it might fetch as much as £8
billion.
Then there were the first signs of a wobble. The debt markets, which for the
past two years have been shovelling out money to satisfy the voracious
appetite of the global private-equity machine, began to look vulnerable.
Last week banks that had backed huge buyouts at companies such as Alliance
Boots and Chrysler admitted that they were struggling to offload the debt
they had put up to finance the deals.
And on Thursday evening – just days before Cadbury had hoped to announce a
deal to sell its drinks business, the company yielded to the inevitable.
Astatement was drafted for the stock exchange the following morning: the
deadline for bids for the drinks business was to be extended; the turmoil in
the debt markets meant potential bidders had to be allowed more time to
raise the money.
A Cadbury executive tried to make light of it: wasn’t it a shame that Nelson
Peltz hadn’t intervened a month earlier? Had he done so, the sale would have
all been tied up before the debt market headed south. The joke was lost on
Cadbury’s chief financial officer Ken Hanna. He struggled to raise even the
thinnest of smiles.
The experience of the Cadbury deal illustrates perfectly the change in mood
that has overtaken the debt markets in just a few weeks. The glut of
financing has evaporated. Investors have once again realised that there is
such a thing as risk. Deals are in jeopardy. And the effects have spilled
over into the equity markets. IN TRUTH, it is not the new environment that
is unusual: the market’s current valuation of risk is returning to something
approaching the long-term norm.
But the few months leading up to last week’s shake-out were indeed
exceptional. Markets were awash with liquidity: money was unprecedentedly
cheap and plentiful.
Private equity found itself with huge sums at its disposal – and thus scores
of quoted companies felt themselves under threat of takeover. The markets
gorged on liquidity. It was an orgy of excess. Risk? Nobody cared. Money was
there for the taking – with no questions asked.
The figures give some indication of the scale of the excess – and just how
carefree investors had become in lending to buyout vehicles. Standard &
Poor’s estimates that in 2004, the ratio of debt to companies’ operating
cashflows – earnings before interest, tax, depreciation and amortisation –
was typically 4.9. The ratio has edged towards 6 recently. Some deals were
even being struck at a ratio of 10.
“Virtually anyone could borrow,” said one investment manager. “A lot of people
were able to jump on the bandwagon when they didn’t necessarily have the
skills. How many people really knew the risks they were taking and how to
manage them?
“It’s only if there is some economic slowdown that we will discover who has
the skills and who doesn’t. Just like Warren Buffett said: it’s only when
the tide goes out that you learn who’s been swimming naked.”
Quite naturally, those who were gleefully joining in the orgy of deals now
insist that they knew all along it couldn’t last. One banker said: “Common
sense has intervened at a time of exuberance. If you had asked me two months
ago whether I thought leverage levels were appropriate, I’d have said: of
course not. It would be unstable for one, two, three months, then readjust.”
And will the economic tide indeed go out? On the face of it, last week’s
sell-off in the stock markets was triggered by appalling figures for the
American housing market, confirming the biggest slump in residential
property since the early 1990s.
That housing market crisis threatens to undermine the market for lending.
Defaults are increasing. And significantly, Countryside Financial, America’s
biggest mortgage lender, has warned that defaults on loans are not confined
to the so-called sub-prime market – loans to borrowers with poor credit
histories. The problem is spreading to other borrowers, said the lender as
it announced a big drop in earnings.
America’s sub-prime woes pose two threats. First, they may slow the American
economy, which has been the motor of global growth, with US households
acting as the world’s consumers of last resort. Second, losses on mortgages
threaten to spread through the financial system, sparking a clampdown on
lending and falls in the price of assets such as equities.
In Britain, too, the economy could suffer if – and it’s a big if – the
financial-services sector took a hit. Business and financial services
accounted for half of UK economic growth last year. Figures last week showed
that Britain’s housing market is already slowing: the Nation-wide said
prices had risen only 0.1% in the past month.
But America remains the key to global prospects. Will the latest turmoil
really bring the American economy to its knees? Lewis Alexander, chief
economist of Citigroup in New York, said last week that the economic
fundamentals remain sound. Long-term interest rates are still low. Corporate
profitability remains robust. And, Alexander said, the prospect of a “credit
crunch” – where lenders face losses on one set of loans and have to call in
others – remains remote.
The Bush administration is keen to quell any sense of panic. Speaking after a
meeting with his economic team at the White House on Friday, President
George Bush said: “The world economy is strong and I happen to believe one
of the main reasons why is because we remain strong.”
His Treasury Secretary, Hank Paulson, said: “What we are seeing is risk being
repriced and a different perspective on risk, which I think is healthy.”
Paulson said the correction was a “wake-up call” to investors. “When you go
through good times, discipline sometimes gets a bit lax,” he said. He
insisted that the fundamentals of the American and the global economies
remained strong. “Markets are always going to have readjustments. We have a
strong economy globally and I take great comfort from that.”
Not everybody is so sanguine. “The deflating American housing bubble and its
knock-on effects promise to hold US growth below trend during the second
half of 2007,” said Ian Harwood, chief economist at Dresdner Klein-wort.
“Not only do we think no end is yet in sight for the American housing
‘adjustment’ but, in addition, there is a clear and present danger of a
generalised credit crunch.” He sees a 40% chance of an outright recession in
America.
And where do the latest upheavals leave the market for leveraged buyouts
(LBOs)?
In 2006, loans to finance LBOs totalled more than $500 billion (£247 billion)
– a doubling in just two years. The pace of borrowing was sustained in the
first half of this year, at more than $220 billion. As a proportion of the
domestic product of the G7 group of industrialised countries, LBO financing
is now at its highest level since the late 1980s. The driving force has been
the glut of cheap money.
Suddenly, lenders are rediscovering the notion that no lending is risk-free.
The balance of power between banks trying to syndicate loans and the
investors they want to take on those loans has changed.
James Dunnett, a partner at the City law firm Norton Rose, said: “Investors
can be more discerning about the credit quality of the deals they are
prepared to accept, and the covenants attached to them. But it is a
correction at the moment, rather than a meltdown.”
A correction, maybe. But a leading City lawyer said the flood of
private-equity deals being syndicated had slowed to a trickle. “I have been
looking at four or five deals a week. In the past fortnight I have seen just
one,” he said. BANKS that have underwritten buyouts are now facing real
difficulties syndicating their loans to other investors. The financial
system is finding it hard to digest the deals it has been wolfing down over
the past two months. Hence last week’s news that banks which backed the
buyouts of Alliance Boots in Britain and Chrysler in America have shelved
plans to sell on debts they incurred.
They are struggling because some investors have pulled out of the market
altogether and the rest have been able to become more fussy. They are much
less likely to accept poor business cases, high-credit risks, and
covenant-lite deals.
This leaves the banks with two options. One is to hold on to the loans, with a
view to selling them when the market recovers, or when the underlying
trading of the business involved has proved it to be a worthwhile
investment. If they do that, the banks restrict the amount of underwriting
they can do, because the loans stay on their balance sheet.
Alternatively, the banks can shift the loans at a discount – say 95p in the
pound. Whether they will make a loss depends on the balance between their
underwriting fees and the discount on the sale of the loan.
And does any of this justify the sell-offs last week? Certainly, some
companies whose share prices have been buoyed by the belief that they would
be bid targets have taken a hit. But companies on both sides of the Atlantic
have fairly strong balance sheets, and in the past few months, corporate
earnings have, on average, been above expectations.
In a note last week, Citigroup’s equity strategy team in London said: “Wider
credit spreads and broader liquidity concerns have driven the current
sell-off. There has been little change so far to the fundamental outlook . .
. In Europe, economists have continued to underestimate the strength of the
economic recovery.”
For Cadbury’s Ken Hanna, it’s little consolation.
DEALS UNDER THREAT
AS the future of EMI teeters on a knife edge this weekend, bankers,
private-equity companies and company executives in the middle of mergers and
acquisitions are wondering if their deals will be the next to be scuppered
by the credit crunch.
In America there is an estimated $200 billion of debt that banks have already
agreed to lend for deals but has not yet been syndicated. These deals
include Blackstone’s $20 billion takeover of Hilton, the hotel group, JC
Flowers’s $25 billion buyout of Sallie Mae, the largest lender to American
students, and the $28 billion takeover of First Data, the credit-card
processing group.
The situation is less severe in Europe, but banks still have about €50 billion
(£34 billion) to shift. Alliance Boots accounts for £13 billion of this but
there is a raft of deals worth about £2 billion each. Top of the danger list
is the £6 billion merger of the AA and Saga, where the debt is underwritten
by Barclays and Mizuho, the Goldman Sachs-backed £2.4 billion buyout of
Endomol from Telefonica, and Bain Capital’s £1.3 billion acquisition of
Brake Brothers.
There are also concerns for deals that don’t yet have financing agreed,
including the Qatari-owned Delta Two’s 600p-a-share proposed offer for
Sainsbury, the Royal Bank of Scotland consortium’s bid for ABN Amro, and the
$23 billion sale of Virgin Media.
One banker said: “If the debt has not been syndicated, you’re too late to the
table already. They’ll get done, but slowly and painfully.”
