LeveragedFinanceReshufflingTheDebtTheCreditImplicationsOfTheNewWaveOfLBOs2.22.11

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Leveraged Finance:

Reshuffling The Debt: The CreditImplications Of The New Wave Of

LBOsPrimary Credit Analyst:Allyn Arden, CFA, New York (1) 212-438-7832; [email protected]

Secondary Credit Analysts:William Wetreich, New York (1) 212-438-7869; [email protected] G Drucker, New York (1) 212-438-7831; [email protected]

Table Of Contents

The Mega Deals Of 2005-2007 Are Likely A Thing Of The Past

Where Are The 2005-2007 LBOs Now?

What Is Behind The LBO Resurgence?

The New LBOs: Transaction Size And Structures

Recent LBOs Have Not Caused Ratings To Fall As Precipitously As In

The 2005-2007 Period

We Expect More LBOs In 2011

February 22, 2011

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Leveraged Finance:

Reshuffling The Debt: The Credit ImplicationsOf The New Wave Of LBOs( Editor's Note: This article is part of Standard & Poor's Ratings Services' "Reshuffling The Debt" series, which we

launched at the beginning of 2011. The series rekindles the "Leveraging Of America" series of articles that Standard

& Poor's published in 2007, which commented on the large increases in nonfinancial corporate issuers' debt

leverage shortly before the Great Recession began. "Reshuffling The Debt" investigates the leveraging trends of

these entities now that we are in the wake of the recession.)

Are we approaching another boom period for leveraged buyouts (LBOs)? Private equity firms have been completing

more of these deals since early 2010, bolstered by a modestly improving economy, healthier credit markets,

increasing appetite for risk among bond investors, and low interest rates. These companies have large amounts of

cash, possibly over $400 billion in total, and generally will need to invest much of it over the next few years.

Therefore, Standard & Poor's Ratings Services expects this pickup in LBO activity to continue in 2011. However,we believe the days of mega LBOs--$10 billion to $15 billion in size or greater--will likely remain in the past, given

current market conditions.

The Mega Deals Of 2005-2007 Are Likely A Thing Of The Past

The surge in buyout activity during the boom period of 2005-2007 was the result of substantial inflows into private

equity funds, low interest rates, a robust collateralized loan obligation (CLO) market, and narrow spreads for

corporate--especially speculative-grade--debt. These factors encouraged increasing transaction sizes and allowed for

several large mega-cap deals, including the acquisitions of HCA Inc. for $34 billion in November 2006 by a private

equity consortium and First Data Corp. for $29 billion in September 2007 by Kohlberg Kravis & Roberts (KKR).

Such LBO giants carried greater debt burdens and significantly weaker credit protection measures than their

predecessors. Moreover, we originally rated several issuers around the middle of the credit spectrum ('BBB' to 'BB')

prior to their LBOs. Some examples included the buyout of Harrah's Entertainment Inc. (rated 'BBB-' with a

negative outlook prior to the announcement of the transaction) in January 2008, Univision Communications Inc.

(BBB-/Stable/--) in March 2007, and Freescale Semiconductor Inc. (BBB-/Stable/--) in December 2006. As a result,

the deterioration in credit measures and overall ratings was steeper than the declines caused by more recent LBOs.

Companies also structured debt transactions with weaker creditor protection, including "covenant-lite" loans and

payment-in-kind (PIK) toggle notes, where borrowers can make interest payments with cash or additional debt.

These measures, however, did provide additional structural flexibility, which, to some extent, eased the pressure on

credit quality from the ensuing Great Recession and poor credit market conditions.

There are some important distinctions that have characterized the recent wave of LBOs compared to the one that

took place a few years ago:

• Smaller transaction sizes;

• Lower debt burdens and better credit measures;

• Fewer structures with weak creditor protection provisions;

• Higher equity participation;

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• Less liquidity from structured vehicles, such as CLOs; and

• Successful target companies have been non-investment grade, so there is less ratings impact from the LBOs than

on investment-grade targets.

Nevertheless, Standard & Poor's believes that a low interest rate environment, strong credit markets, large cash

positions held by private equity investors, and an increasing appetite for risk will result in an ongoing flow of LBO

deals. We also expect these transactions will have somewhat greater debt burdens and weaker credit measures going

forward, although it is unlikely that we will experience a resurgence of the mega LBOs that occurred from 2005 to

2007, given current credit market conditions.

Despite current robust high-yield bond and syndicated loan markets, the CLO market has dramatically shrunk from

peak levels. Moreover, Standard & Poor's believes that more stringent banking regulations, in their various forms,

will lead to higher capital requirements and more refined leverage constraints at banks. This will make it difficult for

banks and CLOs to fuel a substantial surge in LBOs.

Where Are The 2005-2007 LBOs Now?From 2005 to 2007, we witnessed some of the largest LBOs in history, with several transactions exceeding $20

billion. There were only a few success stories, including ALLTEL Corp., which Cellco Partnership (d/b/a Verizon

Wireless) purchased only seven months after the completion of the LBO transaction was completed in November

2007. We downgraded discount retailer Dollar General Corp. to 'B' with a stable outlook from 'BBB-' with a

negative outlook following its acquisition by KKR for about $7.5 billion in July 2007. However, credit quality

improved over time due to strong operating performance from the company's value proposition during difficult

economic times. We later raised the rating to 'BB-' following the successful completion of the company's IPO. We

raised the rating again in June 2010, and it now stands at 'BB' with a stable outlook.

Most of the other LBOs of this period did not fare as well. Companies such as Tribune Co. and Station Casinos Inc.

filed for Chapter 11 bankruptcy in December 2008 and July 2009, respectively. Realogy Corp., a residential real

estate franchisor, fell on hard times due to a declining real estate industry and an overleveraged balance sheet. We

initially lowered the corporate credit rating to 'B+' from 'BBB' (both with a negative outlook) when the LBO

transaction was completed in April 2007. We currently rate Realogy 'CCC' because of the company's thin interest

coverage of 1x.

Freescale Semiconductor (B-/Watch Pos/--) suffered from its high customer concentration with a cell phone

manufacturer and the auto industry's steep decline. We lowered our rating on the company to 'BB-' with a negative

outlook from 'BBB-' after the transaction closed. The current rating largely reflects its elevated leverage of about 8x

and its exposure to the now improved, but still below peak, auto industry, along with its recent IPO filing.

Table 1

Examples Of LBO Rating Migrations (2005-2007 LBO Deals)

CompanyTransactionsize (bil. $) Sector

Pre-LBOrating/outlook

Post-LBOrating/outlook

Ratingdifferential

Post-LBOadjustedleverage

Currentrating/outlook

Energy FutureHoldings Corp.

44.5 Utilities BBB-/Negative B-/Stable 6 notches -- CCC+/Negative

HCA Inc. 33.8 Health Care BB+/Stable B+/Negative 3 notches 7.0x B+/Stable


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Leveraged Finance: Reshuffling The Debt: The Credit Implications Of The New Wave Of LBOs



Table 1

Examples Of LBO Rating Migrations (2005-2007 LBO Deals) (cont.)

First Data Corp. 28.7 High Tech A/Stable B+/Negative 8 notches 9.0x B/Stable

Harrah'sEntertainment Inc.*

27.8 Hotels &Gaming

BBB-/Negative B+/Stable 5 notches 9.5x B-/Stable

ALLTEL Corp. 27.0 Telecom A-/Watch Neg B+/Negative 7 notches 10.0x NR

CC Media HoldingsInc. (Clear Channel)

24.5 Media BBB-/Negative B/Stable 3 notches 10.0x CCC+/Positive

Knight Inc.¶ 21.0 Energy BBB/Stable BB-/Stable 4 notches -- BB/Stable

FreescaleSemiconductor Inc.

18.4 High Tech BBB-/Stable BB-/Negative 3 notches 5.6x B-/Watch Pos

Intelsat Ltd.§ 16.4 Telecom BB-/Stable B/Stable 2 notches 9.1x B/Stable

Tribune Co. 14.5 Hotels &Gaming

BBB-/Negative B/Negative 5 notches 9.5x NR

UnivisionCommunications Inc.

13.7 Media BBB-/Stable B/Negative 5 notches 12.0x B/Stable

SunGard DataSystems Inc.

11.5 High Tech BBB+/Watch Neg B+/Stable 6 notches 7.0x B+/Stable

Realogy Corp. 9.3 Hotels &Gaming

BBB/Negative B+/Negative 5 notches 10.0x CCC/Positive

Station Casinos Inc. 8.8 Hotels &Gaming

BB-/Watch Neg B+/Negative 1 notch 10.0x NR

ARAMARK Corp. 8.1 ConsumerProds

BBB-/Stable B+/Negative 4 notches 7.0x B+/Stable

Dollar General Corp. 7.2 Retail BBB-/Negative B/Negative 5 notches 8.0x BB/Stable

Neiman MarcusGroup Inc. (The)

5.3 Retail BBB/Watch Neg B+/Stable 5 notches 6.5x B/Stable

Average 18.9 8.7x

*Now known as Caesar's Entertainment Corp. ¶Now known as Kinder Morgan Inc. §Now known as Intelsat Global S.A. NR--Not rated.

What Is Behind The LBO Resurgence?

In 2010, LBO transactions totaled $79 billion, compared to only $13 billion in 2009, though still substantially

lower than the $434 billion of LBO deals recorded in 2007, the peak year of take-private activity. We believe several

factors are propelling this new wave of LBO transactions. Private equity firms are flush with cash from institutional

investors and they need to place this capital relatively quickly, as they often have up to six years to invest the funds

raised or release investors from their capital commitments. Moreover, valuations remain attractive relative to

historical trends. Following the 2008-2009 credit crisis, many of the 2010 transactions involved greater equity

participation and lower valuations, resulting in less leverage, which made them more attractive to investors and

banks. In fact, equity contribution in LBO transactions averaged about 41% in 2010, versus 31% in 2007.

However, some new deals in 2011 feature somewhat less equity cushion, including the $5.3 billion acquisition of Del Monte Foods Co. by a consortium of private equity firms led by KKR. We expect this transaction to have a

32% equity cushion.


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Other factors contributing to the increase in LBO activity, we believe, are low interest rates and healthier credit

markets. These factors, coupled with improving corporate earnings and stronger credit profiles, have resulted in

tighter spreads for corporate debt issuance relative to 2009. According to Standard & Poor's Leveraged

Commentary & Data (LCD), the average institutional LBO loan spread was 462 basis points over LIBOR in 2010.

While spreads have tightened from very high levels in 2009, we note that they are still above recent historical trends

and could improve over the next year, especially if credit conditions remain healthy. Additionally, lender demand for

corporate debt is robust, and oversubscription of deals has often led to a flex-down in pricing for recent deals from

initial levels. Tightening spreads for corporate debt, combined with the recent declines in equity contribution frompeak levels, could potentially result in higher leverage and larger transaction sizes for future LBO deals.


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Still, we have seen a few instances where proposed large LBOs have fallen through. One example was the proposed

$7 billion buyout of hard-disk drive manufacturer Seagate Technology (BB+/Watch Neg/--) in October 2010.

According to LCD reports, the company decided to terminate discussions because the valuation was not attractive or

in its shareholders' best interests. However, Seagate remains on CreditWatch as we assess its future financial policy.

Another large LBO transaction that was not completed was the proposed $15 billion acquisition of U.S. banking

and payments technology provider Fidelity National Information Services Inc. (BB/Stable/--) in May 2010 by a

private equity consortium led by the Blackstone Group, also reportedly because of a disagreement on valuation. This

transaction would have represented the largest LBO deal since the 2008 financial crisis. Instead, the company endedup pursuing a leveraged share repurchase program that resulted in a one-notch downgrade.

The New LBOs: Transaction Size And Structures

While the number of LBOs increased in 2010, transaction sizes were significantly smaller, with few deals exceeding

$5 billion in total value. The average LBO size was $1.0 billion in 2010, compared to $2.1 billion in 2007, but it is


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still higher than the 15-year average of around $800 million. Moreover, overall credit protection measures

associated with LBO deals are healthier than in the 2005-2007 period, and we saw fewer instances of weak creditor

protection provisions, such as covenant-lite loans and PIK toggle notes. According to LCD, average pro forma debt

leverage (total debt to EBITDA) was around 4.8x (not including Standard & Poor's adjustments) in 2010, compared

to 6.1x in the peak year of 2007. Moreover, credit measures are also comparable with the average over the past

decade.

Nevertheless, Standard & Poor's believes that new take-private deals could have increasing levels of debt, reduced

equity participation, and weaker credit protection measures over the next year. In fact, some of the recently

launched LBO transactions have carried more aggressive capital structures. For example, pro forma unadjusted

leverage for the recent Del Monte Foods Co. LBO is 6.7x (6.8x adjusted), while leverage for the Burger King Corp.

take-private acquisition was 5.9x (6.8x adjusted). Additionally, we have started to see a resurgence of less

credit-friendly trends, such as with the CommScope Inc. (B+/Negative/--) and Gymboree Corp. (B+/Stable/--) LBOs,

both of which had covenant-lite term loans. Other LBO deals, such as Del Monte and J. Crew Group Inc.

(B/Stable/--), also included term loans with weaker protective covenants.


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LBO transactions have had stronger credit measures than the ones during the 2005-2007 period. The average

leverage (including Standard & Poor's adjustments) for some of the largest rated LBO deals was about 6x, versus

9x for earlier large deals (see tables 1 and 2).

• In some cases, our rating prior to the LBO transaction already anticipated a potential increase in leverage.

We Expect More LBOs In 2011

We expect the LBO resurgence to continue in 2011, assuming that the credit markets remain healthy. Are the

markets suffering from "credit amnesia" or will there be some resistance by banks and investors as new deals come

to market? Private equity firms still have strong cash balances, which they need to invest sooner rather than later.

And companies are making deals with greater debt components, enhancing their appeal to private equity investors.

According to LCD, the average leverage multiple of large LBOs (those with more than $50 million of annual

EBITDA) was over 5x in December 2010 and January 2011--higher than the average LBO leverage for all of 2010

and above the norm for the past decade. The environment is currently favorable for more LBOs, although we do not

presently expect a return to the mega deals of the recent past. In an evaluation of some of these mega LBOs, we

believe that only a handful performed well from a credit perspective. As a result, we believe debt and private equityinvestors will be wary of excessive leverage and large transaction sizes, and the significant equity investment

required. Additionally, the CLO market no longer provides as meaningful a source of liquidity to fund mega-LBO

deals. A more likely scenario is that LBOs continue over the coming year at an active pace, but are structured with

only modestly higher leverage than in 2010, with less equity cushion and fewer creditor protection provisions.


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LeveragedFinanceReshufflingTheDebtTheCreditImplicationsOfTheNewWaveOfLBOs2.22.11

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