VideoAs the financial markets squealed in pain last August and frozen leveraged-buyout deals had bankers pulling their hair out, health-care distributor Henry Schein was in a different frame of mind. It was extending a $57 million offer to acquire the shares of New Zealand–based Software of Excellence, a developer of practice management systems for dentists.
Not that Henry Schein's executives didn't worry about the spreading subprime-debt fiasco. A credit crunch, billions in stuck deals, and an eerily uncertain situation provided plenty of cause for concern. But fear was not the overriding theme at Henry Schein's Melville, New York, headquarters. In fact, if one clear message emerged, it was that this was a good time for the $5 billion company to step up its acquisitions.
"For companies like ours that are in a strong cash position and have financing in place, this [credit crunch] is an advantage," says Steven Paladino, CFO of Henry Schein, which has $200 million in cash as well as an untapped line of credit. "We can do transactions without a financing contingency."
Not all companies are as fortunate as Henry Schein. A five-year stretch of plentiful and cheap borrowing is over, the subprime-mortgage meltdown having ushered in a new reality. Banks have tightened lending, borrowing costs have risen, and tolerance for risk has fallen off a cliff. Besides putting a number of mortgage lenders out of business and virtually shutting down the LBO pipeline, the crunch is altering the financing landscape for all companies going forward.
In many ways, the turmoil is self-inflicted — overissuance of leveraged paper to feed the LBO machine combined with overissuance of subprime mortgages to feed Wall Street's securitization engines. Record underwriting in both categories the past few years resulted in looser lending standards and removal of covenants. The system hummed until June, when investors balked and demanded higher payment for risk.
Assuming no further deterioration in the economy, the effects should be painful but not catastrophic, limited to what Wall Street calls the elimination of froth and the return of reason. But if economic conditions deteriorate, then everything from moderate pain to a full-blown recession is on the table. "The biggest risk is the economy," says Mike Jackson, segment leader of the corporate banking group at KeyBanc Capital Markets. "If the economy turns and you start to see true defaults, that will cause a natural tightening to the credit cycle."
For now, it is companies with leveraged-up balance sheets that are feeling the squeeze. For them, debt has become pricier and more scarce. And those planning a payday through a sale to private-equity players may not see that day anytime soon. But solid credits with strong banking relationships should be able to finance without a problem, Jackson says. In fact, some can find opportunities in crisis, in the form of cheaper acquisitions and weakened competitors.
The Return of Risk
The sharpening difference between stronger and weaker credits has to do with the way investors view risk. Before the credit turmoil, a combination of low interest rates, plentiful liquidity, a strong economy, and a hot real estate market took the edge off risk, making funding easily available to issuers, including speculative-grade companies. Leveraged loans, which weaker companies use to raise capital, exploded, hitting a record $427 billion in the first half of 2007, a 42 percent increase over 2006, according to Fitch Ratings.
Credit spreads narrowed on lower-grade securities as credit eased, meaning that investors were willing to accept little reward for taking extra risk. For example, spreads on high-yield corporate bonds, which were 818 basis points in March 2003, narrowed to 282 basis points in early 2007, according to the Securities Industry and Financial Markets Association. During the same period, spreads on subprime mortgages also shrank. As long as real estate prices kept rising, all was well.
But as real estate prices began to fall and subprime-mortgage defaults rose in late 2006 and early 2007, securitized bonds containing subprime mortgages collapsed, shaking investor confidence. By summer, investors were rejecting low-yielding, risky debt that carried lax issuance standards, including around $350 billion in leveraged financing, mostly for LBOs, basically shutting down the deal machine. As the market struggles to regain its footing, yields for lower-grade investments are climbing as investors demand more pay for risk. That trend is expected to continue. "As much as we thought it was different this time, it was not — there will be a reassessment of risk," says Art Hogan, director of global equity product at Jefferies & Co.
Rising interest on high-yield debt endangers highly leveraged firms. Businesses with lower credit ratings tapping the high-yield bond market are paying an average of 2 percent more than they did in early summer, according to Fitch. Spreads have widened to 456 basis points over 10-year Treasury notes as of early September, versus 240 basis points in early June.
Higher interest rates make it more difficult for speculative-grade corporations to refinance by issuing new debt. This could well kick off a wave of defaults and bankruptcies. Edward Altman, director of the credit-and-debt-markets program at New York University's Salomon Center, Stern School of Business, says high-yield debt issuers typically begin defaulting in the second year after issuance, and nonperformance accelerates in the third and fourth years. That scenario doesn't take into account outside conditions such as the economy and liquidity, he says. High liquidity, for example, can keep such companies propped up, as it did during the credit bubble, but with credit tighter, more bankruptcies are likely, Altman says.
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