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Home / Mutual Funds / News /  Risk of leveraged buyouts keeps bondholders on alert

 

BY Lorena Ruibal | UPDATED DEC 13, 2021 04:34 PM EST

The number and value of c by private-equity firms have reached record highs on both sides of the Atlantic

A recent surge in takeovers of companies by private-equity firms is a major concern for managers of corporate-bond funds, who are having to be carefully selective when picking which bonds to buy.

Private-equity firms typically load companies with debt to finance such purchases, in what is known as leveraged buyouts, or LBOs. The extra debt risks leading to a credit-rating downgrade of the company’s existing bonds, driving their price lower and causing losses on investors’ portfolios.

“Part of our job as a corporate bond managers is to try to identify which companies are at risk of a leveraged buyout," said Lucy Speake, head of European credit and deputy head of fixed income at Insight Investment.

Colin Finlayson who co-manages the £437 million, equivalent to $579.9 million, Aegon Strategic Global Bond Fund said he “wouldn’t think twice about cutting back in positions where there’s some risk of M&A activity."

Fueled by a surge in cheap money due to recent massive asset-purchase programs by central banks seeking to boost economies that have been harmed during the pandemic, the number and value of leveraged buyouts by private-equity firms have reached record highs on both sides of the Atlantic.

European private-equity firms have carried out 4,130 leveraged buyout deals worth €570.9 billion, equivalent to $646.1 billion, through the year to Dec. 6, according to a PitchBook. Their U.S. counterparts have deployed $845 billion through 5,123 deals.

“Debt is very cheap," said Insight’s Ms. Speake. “Private-equity firms have a huge amount of dry powder at the moment, as investors are looking for higher returns."

Low interest rates and meager returns have pushed a large number of investors, including pension funds, into alternative investments such as private equity, she said.

According to data from Preqin, U.K.-based private investors are sitting on $312.9 billion of cash, while their U.S. counterparts still have $1.84 trillion to deploy.

LBO candidates are typically asset- and cash- rich companies with depressed share prices and are underleveraged relative to their peers. Private-equity firms will look to take them private, turn them around and sell them on to other companies or to the public.

Some bond investors have cut their exposure to target companies as buyout talks emerged, and the trend means credit fund managers are having to be cautious about which bonds they buy.

“It’s a bit more complex than sort of running for the hills from a particular sector or from a particular name," said Annabel Rudebeck, head of non-U.S. credit at Western Asset Management. “We’re being very careful on the specific bonds that we choose."

Supermarkets, telecom firms and U.K. pub operators are prime examples of companies that are in the firing line, analysts said.

U.K. retailer Marks & Spencer Group and Italy’s major telecommunications provider Telecom Italia and are among the companies that have fallen prey to recent reports of buyout interest from private-equity firms, leaving investors scrambling to ditch their bonds.

M&S’s bond due on June 2025 has fallen to 108.775 on the pound, according to Tradeweb, compared with 110.595 on Nov. 19 before reports emerged that New York-based private-equity firm Apollo Global Management was considering a buyout bid for the retailer.

Telecom Italia’s July 2027 bonds have dropped to below par, from 100.619 on the euro before KKR launched a bid for the Italian group.

While no formal bid for M&S has materialized, Telecom Italia picked advisers a week ago for a KKR takeover approach. The total Telecom Italia buyout bid would be €33 billion, including €22.5 billion of net debt. If successful, it would represent one of the largest private equity buyouts of a European company in history.

The current heightened speculation of leveraged buyouts follows two recent high-profile deals.

Shareholders in the U.K.’s fourth-largest supermarket group Wm Morrison Supermarkets PLC accepted a £7.0 billion takeover offer from U.S. private-equity firm Clayton, Dubilier & Rice in October, the largest private equity buyout so far in Europe.

In the same month, Blackstone Group Inc., Carlyle Group Inc. and Hellman & Friedman LLC struck a deal to buy medical-supply firmMedline Industries Inc. for $34 billion, marking the largest leveraged buyout since the 2007-2008 global financial crisis.

Some fund managers prefer to avoid bonds with buyout risk, others may choose to buy the bonds when prices fall.

However, LBOs don’t always mean losses for bondholders. Some can even be advantageous, and corporate-bond investors need to be discerning.

“It’s not straightforward that if a company gets junked [is downgraded to junk status] that it’s bad for investors. It can actually be an opportunity," said Insight Investment’s Ms. Speake.

Some types of bond covenants, such as a “change of control" option, safeguard the interests of bondholders. This provision allows the bondholder to sell back the bonds to the issuer at a premium.

“It’s been really important which bonds you own because you’ve often got protection in the form of change of control," said Western Asset Management’s Ms.l Rudebeck said.

After taking Wm Morrison private, CD&R launched a tender to buy back four of the supermarket chain’s sterling bonds at a premium.

This move suggests some private-equity firms may be prepared to compensate existing bondholders to scrap old covenants or to change the specific mix of debt and equity used to finance a company’s assets and operations.

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