Behind the terms of Harrah’s Entertainment’s recent agreement to be acquired by two private-equity firms last week were some potentially important signals about where the current buyout boom is going.
Earlier last month, Harrah’s accepted a $17.1 billion buyout offer from Texas Pacific Group and Apollo Management that would involve the casino operator taking on around $10 billion in new debt, nearly doubling down on $10.7 billion in existing obligations.
Harrah’s, which generates around $2.5 billion in cash flow each year, will end up with total debt that is more than eight times that amount, a ratio “that is high by any standard,” said Adam Cohen, an analyst at debt-research firm Credit-Sights.
Analysts look closely at a company’s ratio of debt to cash flow — as measured by operating earnings before charges like interest, tax, depreciation and amortization — for a sense of whether it is taking on more debt than it can handle.
A look at recent buyout deals shows that they aren’t only getting bigger in dollar terms, but larger companies are being pushed to pile on increasingly heavy loads of debt.
Private-equity investors — which make money by buying control of companies in the hope of cashing out through a stock offering or outright sale — have been emboldened by low interest rates and generous credit markets. They are pushing companies further out on a limb in the process.
In some cases, this gives their newly private companies little breathing room to execute growth plans and stay afloat were economic and market conditions to turn sour.
In many cases, companies will need to devote at least half their yearly cash flow to meeting interest payments on their debt.
Corporations acquired in leveraged buyouts in the fourth quarter have a ratio of debt to cash flow of 5.7 times on average, according to Standard & Poor’s Leveraged Commentary & Data Group. That is up from an average of 5.3 times in 2005. In 2002, when lenders were less willing to finance risky deals, this ratio was close to 4.0.
The last time leverage in buyout deals averaged 5.7 times cash flow was during the merger boom of the mid-tolate 1990s. In the years that followed, some debt-heavy companies, like barbecue-products maker Diamond Brands and animal-feed producer Purina Mills, defaulted on their debt when their bets went wrong.
This time around, analysts expect leverage to rise further before cracks show, and some of the buyouts this year already are stretching those limits. Hospital operator HCA, which was taken private this fall, now has total debt of close to $28 billion, 6.5 times its current cash flow. Kinder Morgan’s buyout will boost its debt to around $14.5 billion, also more than six times its cash flow.
Station Casinos Inc., which this month received a buyout offer, could end up with debt of more than nine times its cash flow.
The rising leverage in transactions means companies “have to make sure they hit all their targets and fire on all cylinders,” said Gregory Peters, a credit strategist at Morgan Stanley. “They are putting more of their business model at risk, and there is no room for error,” he added.
As buyouts become more prevalent, shareholders are demanding higher prices for their shares before they will allow their companies to be taken private. To meet those demands, private-equity investors are borrowing more to finance their acquisitions, and banks and credit markets that are flush with cash are more than willing to lend money to them.
The question is whether many of these companies can handle larger debt burdens, especially if interest rates rise or business conditions change and their revenue and cash flow decline. At some point, many firms that were bought out may seek to borrow more money to refinance their debt or cover their expenses, and there is no guarantee the credit markets will be as hospitable as they are now.
“If a company isn’t doing well and can’t raise more capital at a reasonable cost to cover its shortfalls, it’ll get hit from both sides,” said John Lonski, chief economist at Moody’s Investors Service.
To be sure, the debt behind deals today might not be as great as those that took place in the 1980s. Retailer R.H. Macy, for example, had its debt load rise more than tenfold in 1986 to $3.7 billion when it was acquired in a management buyout. In the following years, it ran into challenging operating conditions and couldn’t generate enough cash to cover its debt payments. The company filed for bankruptcy protection in 1992.