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The Harsh World of Leveraged Buyouts Has Suddenly Gotten Harsher

02-Aug-2007



The abundance of cheap credit which has fueled the leveraged buyout boom is evaporating. Investors fleeing the collapsing US "subprime" property market (based on the sale of mortgages to first-time low income home buyers on ostensibly easy terms which rapidly become onerous) are seeking safety in government bonds and steering clear of the debt which greased the takeover of companies employing millions. Billions of dollars' worth of buyout debt scheduled to hit the markets this year is in financial limbo, effectively putting on hold the funding behind some of the biggest recent private equity deals. Banks have had to peddle small tranches at a discount, eat the losses, and keep the rest of it on their books, where it was never intended to settle.

Suddenly there are no buyers for the 8 billion dollars in junk bonds behind TPG's USD 23.2 billion takeover of Alltel, or the 7-billion dollar junk bond sale underpinning KKR's USD 26 billion buyout of First Data. Financing for the KKR takeover of the UK's Alliance Boots - Europe's largest buyout ever - has been delayed, as has the sale of debt to fund the Cerberus Chrysler deal. In the IUF sectors, Cadbury Schweppes has cancelled the projected sale of its US drinks division, the debt sale to finance the takeover of Ahold's US Food Service has been cancelled, and funding of the TPG Harrah's buyout is delayed.

With rising long-term interest rates and the cost of insuring high-risk bonds against default at a record high, the buyout business is in trouble.

The Wall Street Journal's July 30 list of "Six Ways Private Equity's World Will Be Harsher in Years to Come" views the matter through the prism of the investor, pointing out that "quick flips" and sales of companies between private equity funds will become more difficult as credit dries up. Dividend recapitalizations - the funds' preferred vehicle for getting their money out faster by issuing new debt to finance "bonus" dividends - will likewise become stickier, costlier and quite possibly undoable. As the WSJ points out, this kind of financial engineering is only practicable when debt to earnings multiples are growing, credit is cheap, and a quick, profitable "exit" through sale of the company is within easy range.

What does this mean for workers, particularly for the millions of workers employed by companies taken private by the buyout funds?

An abundance of cheap credit has made it possible for private equity owners to steadily drain corporate cash flow through predatory financing which under normal circumstances would push a company into insolvency. When the exit doors are blocked, and new debt can no longer be obtained cheaply to refinance the old, cash flow is squeezed even harder. The result is likely to be even more pressure to cut costs through layoffs, closures, outsourcing and further reductions in productive investment. Collective bargaining power, already eroded under the buyout onslaught of recent years, will come under heightened pressure. And more company pension funds will face deficits, capping and closure.

The sterile terminology of the finance industry carefully conceals the social reality behind their transactions. The massive eviction of working people from their homes can thus be described as "turbulence in the subprime property market." The leveraged buyout binge of recent years - experienced by most workers as a social disaster - has been hailed for "bringing efficiency to financial markets."

The Financial Times recently suggested that homeowners defaulting on 15% mortgage payments are the real culprits behind the current credit market woes. By the same logic, we may soon be reading in the financial press that a company taken private through an LBO was pushed into bankruptcy by insufficiently thrifty employees.

At the heart of current developments is a massive failure of government regulatory authority, and workers are paying the price. Only now has the US Treasury Secretary seen fit to mumble a few words about "excesses." Regulatory agencies worldwide have simply sleepwalked while the buyout funds and the investment banks offloaded their risk by flooding markets with cheap debt, encoding the funding of debt by more debt in exotic names like "covenant-lite", "toggle loans", and "payment in kind".

Financial markets require regulation because they can wreak enormous social damage when left on automatic pilot. Regulation is also a tool for pursuing democratic policy objectives. Loansharking in the mortgage market cannot substitute for a policy to promote affordable home ownership for working people. The massive transfer of wealth to private equity funds, through tax and other regulatory subsidies, has succeeded spectacularly in enriching a small number of fund managers and bankers who underwrite the deals. It is hardly a method for encouraging an optimal flow of resources into productive investment which benefits society as a whole.

Rather than protecting the public interest by responding vigorously to steadily escalating risk in financial markets, governments have been building the legislative basis for the further expansion of private equity activity. Employee and union pension funds, seduced by the promise of high returns, have been fueling this expansion by systematically increasing their allotments to "alternative assets" even as the unmistakable warning signs accumulated. The credit rating agencies have played a central role in promoting the sale of debt issues which deserved legal investigation rather than a "buy" rating.

It is too early to predict the full impact, scope and duration of the current credit crunch. What has long been clear, however, is that the exponential leveraging of corporate balance sheets is the root cause. For workers and their unions, the world of private equity has always been a harsh one. Now is the time for regulatory action, before it becomes even harsher.

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The leveraged buyout boom and its impact on companies, employees, unions and public policy is described in the IUF publication A Workers Guide to Private Equity Buyouts , available in English, French, German, Japanese, Spanish and Swedish from the IUF secretariat. Regular reports and analysis on buyouts and the IUF sectors are posted on www.buyoutwatch.info where you can sign up to receive e-mail notifications.