Since the reports emerged that 
Dell (DELL) may be subject to a leveraged buyout, bond investors quickly dusted off their LBO handbooks and began to play some defence in their portfolios.
Bonds of those issuers that historically have been identified as LBO candidates were soon offered out into the market, but activity in the secondary market became very sketchy. Trading in those names dried up, as sellers were unwilling to lower their offers enough from pre-Dell announcement levels to entice buyers. Neither sellers nor buyers had enough conviction to find a middle ground in which to cross bonds. In the merger and acquisition community, private equity sponsors are reportedly ramping up their due diligence teams as they scour for targets, and the leveraged finance teams at the large multinational banks are updating their pitch books.
Morningstar's equity and credit analysts have finished their semi-annual Merger & Acquisition Insight. In this report, we highlight firms that we think are takeover candidates as well as firms that are likely strategic buyers. Our credit analysts scoured the bond covenants of potential takeover targets and conducted an upside/downside analysis to highlight those bonds that are most at risk of suffering large losses in an LBO scenario, as well as identify those bonds that may improve from being acquired by a larger, investment-grade corporation.
Credit Markets Primed to Finance M&A
The credit markets are primed to support a greater amount of merger and acquisition activity this year for both strategic acquisitions and a resurgence in leveraged buyouts. With financing capacity returning to the capital markets, debt is plentiful and cheap. Many banks have repaired their balance sheets, have ample credit capacity available to provide commitment letters supporting M&A activity and are increasing their appetite for the wider spreads offered by leveraged deals to help offset contracting net interest margins. In addition, the market for collateralised loan obligations has been heating up. For 2013, CLOs are forecast to raise as much as $35 billion of new capital. The new issue markets for both investment grade and high yield have been especially active thus far this year and are wide open to both repeat as well as first-time issuers. Mutual funds have received significant inflows of new cash that needs to be put to work. Credit spreads are near their lowest levels since the 2008-09 credit crisis, and with interest rates bumping along their lows, the all-in yield to finance acquisitions is at a historic low.
While LBOs appear poised to increase, we continue to think that strategic deals will outweigh financial transactions in 2013. Strategic transactions are becoming increasingly attractive to management teams as corporations are sitting on significant amounts of cash that needs to be deployed, operating margins are near their highs and will be difficult to expand further, and organic growth is difficult at best in the current tepid economic environment. Considering net debt leverage is generally low at most corporations and debt is cheap, most issuers have plenty of bandwidth to finance deals. One trend we think will increase this year is a hybrid buyout in which private equity sponsors are teaming up with strategic buyers. Within these transactions, each party can bring to bear its own strengths such as monetising real estate assets, effecting organisational change, or enhancing operational efficiency.
Considering the average dollar price of bonds in the Morningstar Corporate Bond Index, there is significant downside price risk in an LBO situation, even for bonds with change-of-control provisions, which typically offer downside protection at 101. In addition to the downside risk from leveraging transactions, we expect that in this low-growth environment, management teams will continue to look to financial engineering (that is, spin-offs, asset sales of noncore businesses, and debt-funded share-buyback programmes) to enhance shareholder value as well as ward off hostile leveraged buyouts. Depending on the structure and size of spin-offs, bondholders could be impaired as the remaining cash flow and assets may not provide as much coverage as the combined entity. Asset sales where the proceeds are used to repurchase stock or pay a special equity dividend will also probably result in credit deterioration for bondholders. We encourage investors to scrutinise covenant packages before they purchase bonds to understand if there are any limitations or restrictions on these types of financial engineering.
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