LBOs only going to create more of a problem when this buying frenzy ends. Rachel Beck: Buyout frenzy leaves bondholders with junk Posted by the Asbury Park Press on 05/20/07 While shareholders are cashing in big during the current buyout boom, investors holding what had long been considered the least-risky corporate bonds are taking a surprising bath. It's all about leverage. These days, most takeovers add lots of debt to acquired companies' balance sheets and the result has been credit-rating downgrades of high-quality corporate securities to junk levels. This wasn't the way things were supposed to go for investors, many of whom are pension and mutual funds. They thought they were buying safety with investment-grade corporate bonds, which have a low risk of default. What they failed to appreciate is that many of these bonds don't carry any covenants or change in control provisions that would have allowed them to cash out at a favorable rate before a takeover could be completed. Few expected such protections would ever be needed, given the credit profile that companies long had to maintain to be eligible to borrow funds. But that idea has been turned on its head in the last year. Companies that want to borrow money don't have to look far, thanks to the combination of low interest rates and ample liquidity sloshing around financial markets. That has made these good times for buyout firms, which have used massive amounts of debt to finance deals to take public companies private. The availability of such leverage has allowed them to go after companies that not long ago seemed to be too large to scoop up. So far this year, there has been $166 billion in leveraged buyout lending globally, up 40 percent from the $118 billion seen during the same months in 2006, according to Dealogic. The deals are paying stock owners hefty premiums, some running as high as 50 percent above current share price levels. But those paydays certainly aren't being seen by institutional bondholders. They have watched the value of their investments shrink as acquirers pile debt on to the target company's books, which leads to credit-rating downgrades. Consider the biggest proposed LBO ever, the $32 billion bid by Kohlberg Kravis Roberts & Co. and Texas Pacific Group for Dallas-based power producer TXU Corp. Their plan is to put up less than $8 billion in cash and borrow $24.6 billion against TXU's assets. Should the deal be approved, stock investors will walk away with $69.25 per share, a 25 percent premium over the average closing share price in the three weeks before the Feb. 26 deal was announced. It has gone the other way for investment-grade bondholders, who have no protections to shield them from a buyout. For instance, TXU bonds due in 2024 are now trading around 87 cents on the dollar, compared with highs of more than 97 cents in the weeks before the takeover bid, according to Thomson Financial. The trouble for most holders of high-quality bonds is that they have little recourse to fight back. With no covenants protecting their investments, companies aren't obliged to compensate them for such losses. That was confirmed by a recent Fitch Ratings study of 81 companies that could be targets of an LBO or a leveraged recapitalization, where management takes on debt to fund dividend or stock buybacks to shareholders. Most had no protections for deteriorating credit quality. Most interesting in the report was the advice Fitch gave to its clients: "The best protection for existing holders of bonds of these investment-grade credits is a high stock price, which makes an LBO unprofitable and a leveraged recapitalization unnecessary," it said. All this is leading some bondholders to make demands before deals even getting done. Debt investors at Canadian telephone company BCE Inc., have watched the value of their securities tumble since late March just on the prospects of a takeover. Over the same time, its share price has jumped more than 20 percent. Some bondholders sent letters to the company earlier this month requesting compensation for their holdings should their company be bought out in a highly leveraged deal. "As bondholders, we don't want to subsidize shareholders who are getting bought out," Benoit Durocher, president and CEO of Montreal-based Addenda Capital Inc., who owns bonds in BCE and was one of the investors who sent a letter to the company. At other companies, there is a push for better investor protections in new bond issues. Alcoa Inc. and Federated Department Stores Inc. are among those that added change in control covenants to their offerings this year, according to Fitch Ratings. Chances are more of that will come. Now that investors are waking up to the risks, companies may have a harder time selling debt without protection.