Financial Armageddon: Coming Out of the Woodwork by Michael J. Panzner‏

Posted: 03 Aug 2009 06:10 PM PDT

Back in the spring of 2007 I wrote an article, entitled “Dead Market Walking,” in which I noted the longer-run fallout from the mad dash to acquire financial and other assets using boatloads of borrowed money:

With regard to the technical factors, many market-watchers argue that, especially in recent years, the equity boom has been aided in large measure by a rapidly shrinking supply of publicly-traded equity resulting from corporate buybacks and a plethora of large-scale, debt-fueled leveraged buyouts.

This week’s Barron’s, for example, reports that “since September 2005 some $628 billion of U.S. shares have been repurchased” by listed companies, according to data from Thomson Financial. The publication also notes that “last year, U.S. M&A deals jumped 21 percent to $1.45 trillion, about a fifth of those LBOs.”

These two developments have undoubtedly been a major positive for share prices. Unfortunately, they have also sown the seeds of their own demise: they set the stage for a coming tsunami of equity supply that will eventually overwhelm the market, most likely sooner rather than later.

As the credit cycle turns, companies that have wracked balance sheets in pursuit of short-term operational leverage will quickly discover that borrowing has become a costly financing alternative. With the debt spigot running dry, many will be forced to try and raise equity capital instead, on increasingly onerous terms.

For the swollen ranks of lowly-rated firms that are up to their necks in debt, selling shares — as well as various other assets — will be a matter of survival, often regardless of price.

Meanwhile, frenetically one-sided deal-making by private equity firms and Wall Street bankers will undergo a turnaround, as formerly sanguine players turn into nervous, cutthroat operators looking to cash out while they still can. Suddenly, everyone will understand the maxim that today’s LBO is tomorrow’s IPO and they will rush headlong, like a herd of elephants through revolving doors.

While we have seen something of a scramble before now by the former masters of the universe looking to cash out or shore up shaky enterprises financed with debt, the following report from the Financial Times, “Private Equity Groups in $400bn of Debt,” suggests that an army of cash-raisers and asset-sellers will soon be coming out of the woodwork.

The biggest private equity groups are sitting on a $400bn debt mountain that needs to be repaid over the next five years, putting the future of some of the largest buy-out deals in doubt.

Private equity firms raised large amounts of bank debt to buy companies between 2005 and 2007.

They face more than $21bn of debt maturities in the next two years, another $50bn in 2012, $115bn in 2013 and $192bn in 2014, according to data from S&P LCD.

With debt still in short supply and expensive, private equity groups are being forced to find new ways to pay down this debt ahead of schedule.

These include putting new equity into their portfolio companies, selling stakes in businesses to strategic buyers and buying back debt in their own companies at a discount.

They are also trying to persuade lenders to extend maturities on existing loans.

Henry Kravis, co-founder of Kohlberg Kravis Roberts, said: “In every company we have that has debt, we consider either buying it in with excess cash flow where that is possible, refinancing it or effecting an exchange of the debt.”

KKR has been reducing debt of several of its portfolio groups including NXP, the Dutch chipmaker, and ProSiebenSat.1, the German broadcaster.

The private equity group succeeded in pushing back the maturity date on loans coming due in HCA, the US hospital group that it took private for $33bn in one of the biggest buy-outs of the boom, by issuing $1.5bn of bonds earlier this year.

The urgent need to refinance the debt mountain is driving private equity groups to the high-yield bond market, which has been virtually closed since mid-2007 at the start of the credit crisis.

The level of corporate high-yield bond issuance in Europe and the US in the past three months rose to its highest level since the peak of the debt boom in mid-2007, according to data from Dealogic.

“We think in most cases we can refinance these companies and increase their earnings enough to reduce and refinance the debt,” said Tom Lister, co-managing partner of Permira.

“Private equity owners across the world have started early on this effort.”