Wednesday, April 23, 2008

Smart way to debt freedom

The crisis in the global financial markets has raised bond yields to ridiculously high levels. Well that’s known to all. When defaults are likely, bonds quote at a significant discount to their offer price that pushes their yields up.

PE funds raise leveraged debt (on their portfolio firms) to fund their acquisition and the I-banks that lend to them will securitize that debt and issue bonds to recreate liquidity. These bonds mature at a future date and are to be retired by the future cash flows from borrower firms as they repay. This is the normal cycle.

But when you have a liquidity crisis, these bonds quote at a heavy discount owing to lack of demand and not because of credit worries. Now the original borrowers buy back these bonds at a discount and extinguish the debt. In effect, a company repays the debt that it owed to itself - an anomaly of sorts! This allows them to cut their interest bill, boost earnings and reduce their leverage, all on the cheap. Smart, isn’t it?

How does it matter to portfolio firms of PE funds? For private equity portfolio companies, buying back debt is different to the PE firms investing in debt from their own and other deals. The former is a way to retire debt cheaply; the latter is a new investment by private equity. Lender Banks are revolting.

Recently TDC, the Danish telecoms operator that was Europe’s biggest leveraged buyout when bought for €13bn ($20.8bn) by a private equity consortium in 2005, has unsettled its lenders by buying back €200m of loans at a discount of about 90-95 cents in the euro.

In particular, lenders worry that borrowers will choose to use excess cash to buy back debt at a discount rather than repay debt through formal channels at a par, as required by most standard leveraged loan agreements. The frustration of the lenders at the move by TDC, owned by Apax Partners, Blackstone, KKR, Permira and Providence Equity Partners, has caused the London-based Loan Market Association (LMA) to review its loan documentation guidelines.

Now you can’t have capitalism and fairness. Can you?

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