Junking Your Bonds

Private equity firms are the new financial engineers of corporate America. With interest rates relatively low and corporate balance sheets extremely strong, private equity firms spent an estimated $660 billion last year buying up public companies to take them private. And how do they do that? With debt, which can be very bad news for investors who own bonds issued by those companies.

But some institutional investors are fighting back. Tom Houghton, vice president and portfolio manager at Advantus Capital Management, the investment arm of Securian Financial Group, Inc., in St. Paul, is one of them. Advantus, which manages $3.8 billion in corporate and government bonds, has been at the forefront of a trend that is demanding more protection for bondholders.

{Q} How have leveraged buyouts by private equity firms affected the corporate bond market?

{A} It’s an added element of risk that we haven’t seen in the prior couple of years, and it makes the job of managing corporate bonds that much harder, given the relatively tight valuations between corporate and U.S. Treasuries. Leveraged buyouts can be devastating for bondholders. Basically, when you’re buying an investmentgrade corporate bond, you’re buying a high-quality bond that suggests it will be a BBB- or higher-rated company. Then the next day, when a leveraged buyout occurs, it could be a single-B company or even worse.

{Q} How does a leveraged buyout affect the bond rating?

{A} Well, ‘leveraged’ is the key word in that question. Private equity firms buy out the current shareholders, at a 15 to 30 percent premium on average, and inject about 20 percent equity and fund the rest with debt. So a firm that has 40 percent debt on their balance sheet ends up with 80 percent debt. This is bad for bondholders because, typically, it’s no longer an investment-grade bond, and will trade down substantially in terms of dollar price —so you lose money.

{Q} Have you lost money in your funds because of this?

{A} A very small amount. To quantify, it has cost us about six one-hundredths of a percent of performance relative to the one percentage point or so of excess returns earned across most of our accounts year to date.

{Q} Why such a small amount?

{A} We’ve been fairly successful at avoiding most of these leveraged buyout transactions. Although they’ve covered a broad range in terms of types of companies, most of the transactions have occurred in the industrial sectors. We’ve been overweighing financial companies and utilities and real estate investment trust bonds—these are typically sectors where you don’t see a lot of leveraged buyouts.

{Q} Did we just see a leveraged buyout with Chicago-based Equity Office Property Trust?

{A} Good question. Most real estate investment trusts come with a strong covenant that protects you in the case of a leveraged buyout. Typical of these covenants is an agreement where the company can add only a certain amount of debt to the balance sheet—it’s capped at 60 to 65 percent. So if a private equity group buys a real estate investment trust, even though they’ll want to add a lot more debt than 60 percent—they’ll want to lever it up to 80 to 85 percent—the covenants on these bonds typically prevent that. This means the private equity group will have to buy out the existing debt.

{Q} Is that why the bonds actually increased in price when The Blackstone Group, based in New York, bought Equity Office Property Trust?

{A} Absolutely. The price you have to pay to take out those bonds is typically a lot higher than where the bonds are currently trading.

{Q}Then the biggest risk is in the investment-grade category, where an investment-grade company will be taken out by a lesser-rated entity?

{A} Yes.