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Buyout boom's next phase: greedfest
The buyout and acquisition boom is even hotter than we thought, and investors should benefit through 2006. But let's not forget the downside.
By Jim Jubak
Boom. Wretched excess and shortsighted greed. Bust.
It's a tried-and-true pattern in the financial markets. Right now there's solid evidence that the current boom in buyouts and acquisitions is moving into the excess and greed stage. I don't think the busting of this particular boom is likely to shake global financial markets the way a real-estate bust would (if we get one), but investors can expect it to cause problems for individual stocks beginning, perhaps, by the end of this year.
And, some big investors are clearly starting to position themselves for the buying opportunities that could emerge next year.
In my Jan. 17 column, "Cash in on the great buyout boom," I described a buyout boom headed for new records. Last year, I wrote, "private buyout groups raised a staggering $106 billion, the most ever and a 90% increase over 2004." And that's not the end of the story: 2005, I wrote, was the most active worldwide since 2000 for mergers and acquisitions, with more than $2.7 trillion in deals," up 38% from 2004.
Since I wrote that column -- all of a week ago -- new data has come in showing that this year has started off even hotter than expected. In the first two weeks of 2006, corporate borrowers sold $47 billion in new investment-grade bonds. That's a pace that would easily bust the record for any January of $74 billion, set in 2001.
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Not all that debt is marked for buyouts and acquisitions, but the number is a good indicator for the state of the boom. The total includes $5.75 billion issued by Oracle (ORCL, news, msgs) to pay for its acquisition of Siebel Systems (SEBL, news, msgs), $2.5 billion issued by Johnson Controls (JCI, news, msgs) to fund its acquisition of York International and $500 million issued by Avon Products (AVP, news, msgs) to finance its $1 billion share buyback plan.
Balance-sheet burdens
In the short run -- most of 2006, I'd say -- this boom in buyouts and acquisitions is a huge plus for value investors. As I argued in that Jan. 17 column, all the cash in the hands of aggressive private buyout funds and corporate acquirers puts management at underperforming companies on notice: You, CEO, better get that stock moving and soon -- or we will. That's one reason that I'm expecting value to outperform growth again in 2006.
But in the longer run, the current buyout boom has the potential to weaken corporate balance sheets just in time for the next slowdown in the economy.
Yes, the U.S. economy will slow down sometime, unless Alan Greenspan and Ben Bernanke have managed to repeal the business cycle. The historical average says that sometime is likely to be around the middle of 2007. The average economic expansion since 1945 has lasted 21 quarters. The current expansion kicked off in the fourth quarter of 2001. Tack 21 quarters onto that and you've got the first quarter of 2007.
Why is that important? Because the money that companies are borrowing now creates interest payments that have to be paid whether profits are soaring or souring. And borrowing now, when times are good and lenders are eager to lend, reduces a company's ability to borrow later when times are rocky and lenders are looking to reduce their exposure to corporate debt.
I'm not worried very much when a company like Oracle loads almost $6 billion in long-term debt onto its balance sheet. The company had just $160 million in long-term debt on its balance sheet at the end of the third quarter of 2005 and, according to Prudential Equity Group, the company will generate $2.4 billion in free cash flow in the second half of its 2006 fiscal year and will see operating margins of 40%. The deal to acquire Siebel Systems will turn out to be good or bad depending on the kind of sales and profits Oracle can wring from its acquisition. Paying with debt -- instead of stock -- doesn't really change that equation.
Lipstick on an EPS
I'm concerned -- a step short of worried -- about the number of companies, such as Avon, borrowing to buy back their own stocks. Certainly Avon can handle another $500 million in long-term debt -- it finished the September 2005 quarter with $770 million in long-term debt. Avon's debt-to-equity ratio that quarter was 0.87, well below the 1.54 ratio for its industry and the 1.05 ratio for the Standard & Poor's 500 index.
But while borrowing to buy back shares may make sense to financial engineers when interest rates are so low, it strikes me as an odd way to prop up a stock price by goosing the apparent earnings growth rate. Value Line projects that shares outstanding at Avon Products will sink from 472 million in 2004 to 467 million in 2005, and then to 462 million in 2006. That's reduction in shares outstanding is enough to account for almost all the earnings-per-share growth that Value Line projects for Avon Products from 2004 to 2006. If you keep share counts steady at the 2004 level (so that you divide Avon's earnings by the same number of shares in 2004 and 2006), earnings per share actually drop by a penny from 2004 to 2006, instead of climbing by 3 cents. Granted, even with the buybacks, that's pretty anemic growth. But it sure sounds better than negative growth, doesn't it? (Avon Products isn't borrowing all the money it's using to fund share buybacks, I should note.)
Changing the buyout game
I go from concerned to flat-out worried, however, when I look at some of the current generation of buyout deals concocted by private-equity groups. That's where you'll find the clearest signs of short-term greed at work.
Buyouts traditionally worked like this. A private-equity group -- a Texas Pacific Group or a Kohlberg Kravis Roberts -- would buy an underperforming public company and take it private using some combination of the equity group's cash (typically not much), the company's own cash and cash raised in the debt markets by borrowing against the company's assets. Then, after introducing changes that may or may not have actually been improvements -- such as laying off employees or selling off nonessential divisions -- the equity group would take the company public again. Public investors, rightly or wrongly impressed with the new and improved company, would pony up to buy shares at a price, the equity group hoped, that would provide a heady return on the initial investment. One of the granddaddies of private buyout groups, Kohlberg Kravis Roberts, has pegged its long-term annual returns at 5 to 7 percentage points above the return on the Standard & Poor's 500 ($INX, news, msgs) stock index.
But that traditional process is apparently too slow for some of the players in today's buyout boom. The new trend, according to Standard & Poor's, is for buyout funds to pay themselves first, in the form of fees and special dividends, rather than waiting for the gains from any public offering.
And where is the cash coming from to pay those fees and special dividends? It's borrowed. The result is that some buyout firms are loading even more debt onto the balance sheets of companies that they have taken private -- and that they hope one day to sell in public offerings to investors like you and me.
Here's a typical deal: Three private-equity groups, Thomas H. Lee Partners, Bain Capital and Providence Equity Partners, and individual investor Edgar Bronfman, Jr. put up $1.25 billion of their own money -- about one-third of the purchase price -- to buy Warner Music Group (WMG, news, msgs) in February 2004. By the time the group took the company public again in May 2005, the company had paid them $1.4 billion in special dividends from cash flow and from the proceeds of debt financings. And, not only did the private-equity investors have their initial investment back, but they still own 72% of the company.
And the company that the private investors took public again? In 2005, the company was operating cash-flow positive -- to the tune of $205 million -- but thanks to $917 million dividend payments and $588 million in debt repayments, the company was net cash-flow negative by $267 million. Long-term debt stands at $1.8 billion.
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