Bondholder Backlash

LBO debtholders are getting tougher about protecting their interests.

Whatever the merits of either side, the most pressing question for CFOs is whether courts will allow creditors to sue them directly. Here a decision in a 2004 Delaware case involving Production Resources Group LLC, an entertainment technology firm, may be reassuring. The court decided in that case that officers and directors were protected against the fiduciary claims of creditors by the business judgment rule, which has long shielded managers in cases involving shareholder claims. If that case serves as precedent, creditors would have no standing apart from the corporation to sue officers and directors except in cases of fraud.

But much depends on how federal bankruptcy judges choose to apply that finding. And since bankruptcy proceedings take place in “courts of equity,” judicial decisions there are seldom overturned on appeal. — R.F.

On the Hook

A company’s obligations to creditors in the zone of insolvency are yet another reason to follow good governance practices. In particular, attorneys advise officers and directors of such companies to avoid the following actions, for which, under recent Delaware court decisions, they could be held personally liable:

  • Failing to pay taxes
  • Failing to pay wages
  • Paying dividends to shareholders
  • Sales or transfers for inadequate consideration
  • Violating duties under ERISA

Source: Dorsey & Whitney LLP

Boom and Bust?

Some predict the LBO vogue will be followed by a wave of failures.

Is a downturn in credit conditions imminent? John Addeo, a high-yield bond fund manager for Massachusetts Financial Services (MFS) in Boston, contends that the tougher terms seen recently on high-yield bonds are essentially “deal specific,” and he notes that buyers of bonds financing leveraged buyouts (LBOs) can draw comfort from the vast sums that have been finding their way into the private-equity funds that sponsor the deals.

With the public-equity markets providing mediocre returns, the total raised for private-equity investments was expected (as this issue went to press) to hit a record $250 billion in 2005, according to London-based research group Private Equity Intelligence. What’s more, LBO sponsors now typically put up about a third of the financing themselves. As Addeo notes, that suggests that “sponsors are putting in real dollars, at least initially.”

Yet the proportion of equity in deals involving companies with more than $50 million in earnings before interest, taxes, depreciation, and amortization (EBITDA) has fallen from nearly 37 percent in 2002 to about 29 percent at the end of Q3 2005, according to Standard & Poor’s. Meanwhile, the average ratio of debt to EBITDA exceeded five times at the end of Q3 2005 — up almost a full turn from 2004 and topping the ratio of 4.96 last seen in 1997, according to S&P (see “Leveraged Up” at the end of this article).

That’s still shy of the ratio at the peak of the LBO boom in the late 1980s, which was around six times EBITDA, and equity during that time averaged no more than 10 percent of total financing. However, some of the largest recent deals, including the buyout of Danish telecommunications giant TDC in early December, match the 1980s in terms of leverage.

Even Addeo acknowledges that “there’s been some deterioration in the quality of issuance,” and adds that investors have become more “mistake-aware” of late. Consider, for instance, the case of Tronox Inc., a pigment maker that Kerr-McGee Corp. recently spun off 25 percent of to the public. Originally, Addeo notes, Kerr-McGee hoped to sell the subsidiary to private-equity investors, but couldn’t drum up enough interest, because of the business’s less-than-compelling prospects. And the spin-off came to market at only $14 a share, more than 20 percent below the expected price. Also, Kerr-McGee had to pay a 9.5 percent interest coupon to entice investors to buy a bond issued for Tronox, fully 100 basis points more than initially expected.

It’s that sort of development that leads some bankers and bankruptcy attorneys to predict a wave of debt-driven failures ahead, followed by intense litigation over creditors’ claims. True, corporate defaults have recently been relatively scarce outside the auto and airline industries. But even if rates remain at their current level, marginal companies in other industries will “collapse under the weight of their debt,” predicts Rick Chance, managing director of New York–based Trenwith Securities LLC, a middle-market investment bank. — R.F.


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