Harris Rubinroit's tour de force survey in Bloomberg of the nuances of interest rates in large buyout transactions is a must read for Going Private mavens. Using HCA as a foil, Rubinroit points out five key issues. First, that KKR and Bain will likely be paying some of the highest interest rates since 2001 on the $16 billion they plan to borrow. (Rubinroit uses some sound logic to guess they are near 2.15% over LIBOR and then points out that LIBOR is at a 13 month high).
Second, HCA already is at junk bond credit rating levels (Ba2 from Moody's) but that interest rate spreads were still at record lows for risky loans as recently as April. (Rubinroit cites 1.59% as the spread that month compared to the 2.15% mentioned earlier in his article).
Third, even with the aggressive lending of hedge funds, rates are headed higher. Rubinroit cites Thomas Finke at Babson Capital Management in blaming "more balance between investor demand for loans and supply" for the imminent rises.
Fourth, citing S&P, last quarter buyout firms averaged 5.19x cash flow for acquisitions (4.10x was the average for 2003).
Fifth, all these factors, and others, have contributed to the rise of "covenant lite" loans, with which Going Private readers will likely be familiar as the topic has been addressed here repeatedly. So hooked on low restriction loans have the buyout firms become that it has become habit to simply negotiate up interest rate in favor of limited covenants right off the bat. Interest rate spreads were so "compressed," argues Rubinroit, that covenants became the only effective way for lenders to compete.
The impact of breaking covenants is then well illustrated via reference to Six Flag Inc.'s ongoing renegotiation of $1.03 billion in debt after informing bankers they were unlikely to meet the 4.00x cash flow to interest expense ratio required by the loans and requesting that ratio be lowered to 2.50x. Lenders are likely to extract half a percentage point of LIBOR spread and a quarter point "renegotiation fee" for the concession. I expect this figure is substantially larger than what could have been negotiated from the banks before the covenant was broken.
Additional peeks into Bombardier and Intelsat, Ltd. are well worth the look.