Only the Strong Shall Thrive

Financially sound companies find gold in credit mayhem even as weaker players fear the game is up.

As the financial markets squealed in pain last August and frozen leveraged-buyout deals had bankers pulling their hair out, health-care distributor Henry Schein was in a different frame of mind. It was extending a $57 million offer to acquire the shares of New Zealand–based Software of Excellence, a developer of practice management systems for dentists.

Not that Henry Schein’s executives didn’t worry about the spreading subprime-debt fiasco. A credit crunch, billions in stuck deals, and an eerily uncertain situation provided plenty of cause for concern. But fear was not the overriding theme at Henry Schein’s Melville, New York, headquarters. In fact, if one clear message emerged, it was that this was a good time for the $5 billion company to step up its acquisitions.

“For companies like ours that are in a strong cash position and have financing in place, this [credit crunch] is an advantage,” says Steven Paladino, CFO of Henry Schein, which has $200 million in cash as well as an untapped line of credit. “We can do transactions without a financing contingency.”

Not all companies are as fortunate as Henry Schein. A five-year stretch of plentiful and cheap borrowing is over, the subprime-mortgage meltdown having ushered in a new reality. Banks have tightened lending, borrowing costs have risen, and tolerance for risk has fallen off a cliff. Besides putting a number of mortgage lenders out of business and virtually shutting down the LBO pipeline, the crunch is altering the financing landscape for all companies going forward.

In many ways, the turmoil is self-inflicted — overissuance of leveraged paper to feed the LBO machine combined with overissuance of subprime mortgages to feed Wall Street’s securitization engines. Record underwriting in both categories the past few years resulted in looser lending standards and removal of covenants. The system hummed until June, when investors balked and demanded higher payment for risk.

Assuming no further deterioration in the economy, the effects should be painful but not catastrophic, limited to what Wall Street calls the elimination of froth and the return of reason. But if economic conditions deteriorate, then everything from moderate pain to a full-blown recession is on the table. “The biggest risk is the economy,” says Mike Jackson, segment leader of the corporate banking group at KeyBanc Capital Markets. “If the economy turns and you start to see true defaults, that will cause a natural tightening to the credit cycle.”

For now, it is companies with leveraged-up balance sheets that are feeling the squeeze. For them, debt has become pricier and more scarce. And those planning a payday through a sale to private-equity players may not see that day anytime soon. But solid credits with strong banking relationships should be able to finance without a problem, Jackson says. In fact, some can find opportunities in crisis, in the form of cheaper acquisitions and weakened competitors.

The Return of Risk

The sharpening difference between stronger and weaker credits has to do with the way investors view risk. Before the credit turmoil, a combination of low interest rates, plentiful liquidity, a strong economy, and a hot real estate market took the edge off risk, making funding easily available to issuers, including speculative-grade companies. Leveraged loans, which weaker companies use to raise capital, exploded, hitting a record $427 billion in the first half of 2007, a 42 percent increase over 2006, according to Fitch Ratings.

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