How does Freescale ( FSL), a cyclically sensitive semiconductor company financing a leveraged buyout, sell bonds at a lower yield than a similar offering just one week ago from HCA ( HCA), a huge hospital company with a higher credit rating? Either HCA's bankers screwed up and mispriced the deal, or there is just that much cash chasing high-yield assets -- most likely both. The silver lining for all involved is that the private-equity firms involved buttered up corporate bond investors by giving them some new, high-quality bonds that were priced relatively cheaply (a bond's price moves in opposition to its yield). The buttering is helpful to these sponsors as more giant deals and possible follow-on financing are on the way. "There is a price of admission," says Brian Hessel, managing partner at Stonegate Capital Management. Indeed, these private equity firms' names recur on the announcements of nearly every deal. "If the private-equity firms disappoint high-yield investors, they will have a harder time later getting good execution on deals," says Hessel, among the potential investors for said deals. "The high-yield debt market for LBO'd companies is "like a huge raw material that they need access to, to go forward." Investors can already anticipate some big debt financing deals out of Thursday's announcement that Clear Channel Communications ( CCU) agreed to be bought for $18.7 billion by a private equity consortium including Thomas H. Lee Partners and Bain Capital. Indeed, the high-yield bond market and the leveraged loan market are going to have to maintain healthy appetites (we're talking Thanksgiving dinner) for jumbo bond deals for a long time.
Leveraged buyouts occur when a group of investors, often private-equity firms, chooses to take a company private. The investors usually put in some equity to fund the purchase of shares, but raise the bulk of their financing in the debt markets, typically a combination of high-yield bonds and leveraged loans, which are bank loans broken up and sold off to investors. Because the private-equity investors are making a huge outlay to take an entire company private, the size of the financing is large; that means the company piles on a lot more debt, which often reduces its credit rating and increases its interest costs. Typically, bond investors don't like LBOs because if the company already has debt outstanding, the new debt is typically senior to the existing debt, which means the "old" bonds those investors might already hold decline in value. Private-equity investors hope to make money by eventually bringing the company public at a later date, by raising more money in the debt markets to pay themselves dividends while they control the company, or by selling the company to other investors at a later date. (Thursday's Hertz ( HTZ) IPO being a prime example of the first route.) Freescale's four-part, $5.95 billion bond offering as part of financing for its $17.6 billion acquisition by private equity firms Blackstone Group, Carlyle Group, Premira Funds, and Texas Pacific Group, was priced Thursday via Credit Suisse. The offering includes several portions of bonds with various characteristics. The best comparison to HCA's deal is the largest $2.35 billion, eight-year senior notes portion, which priced to yield 8.875%. The Freescale bonds have a single-B credit rating by Standard & Poor's, and B1 ratings from Moody's Investors Service.
Meanwhile HCA's $5.7 billion worth high-yield bonds that priced last Thursday were rated higher, at double-B-minus by S&P and B2 by Moody's. However, two eight-year senior note portions of HCA's deal priced to yield 9.125% and 9.25%, above the comparable Freescale offering. Typically, higher-rated debt offers lower yields because higher credit ratings mean more security for investors worried about possible defaults on the debt they just purchased. Bond investors scrambled to obtain as much of both the HCA and Freescale deals as they could. Ahead of its pricing last week, investors were bidding up HCA's to-be-priced bonds as high as 103 cents on the dollar, or 3 points over par (the offering price). The three bonds are currently all trading at or above 104 cents on the dollar. "Private-equity firms aren't going to be generous to bondholders, but they don't want to fall on their face either," says Martin Fridson, CEO of research firm FridsonVision and publisher of Leverage World. "To have a big visible deal like HCA's trade to a discount
i.e., a price below its sale price would be hugely damaging." Using a back-of-the-envelope calculation, if the HCA deal were priced at the yields the bonds currently trade, HCA might have "saved" roughly $50 million in interest expense per year for the life of the bonds. Making such claims is a bit misleading, because no one knows if investors would have bought the bonds at those elevated prices from the get go.
The psychology of buying something cheap is powerful. The bond market is still feeling friendly to just about any deal that comes down the pike, as there is still tremendous demand for high-yield bonds, as pensions, insurance companies, and hedge funds chase returns and high-yielding assets, says Hessel. High-yield bonds have returned 10% year to date, according to the Merrill Lynch High-Yield Master II Index. HCA, which is being acquired by a group including Kohlberg Kravis Roberts & Co., Bain Capital, Merrill Lynch & Co and HCA co-founder Thomas Frist Jr., declined to comment. Citigroup, the firm which underwrote its bond offering last week, did not return calls seeking comment. The demand for high-yield bonds, among other high yielding, and more risky asset classes, comes from loose monetary policy and low interest rates around the world which led to still high levels of liquidity. The ensuing demand does and will continue to feed upon the record-setting $285 billion of private equity deals announced this year. Clear Channel's deal was announced Thursday, as was a $2.4 billion offer for Reader's Digest ( RDA) by a group led by Ripplewood Holdings. Deals for Four Seasons Hotels ( FS), and OSI Restaurant Partners ( OSI) were announced last week, among others. Strong demand in the high-yield bond market puts the private equity firms and the companies somewhat in the driver's seat. But the nature of the LBO deal and their reliance on the high-yield bond market means these private equity firms must walk a tightrope. The balance of power gives the bond investor some room to play hard-to-get, and they force the private equity players to exercise some manners. So, even though the high-yield bond market is already frothy, with low risk premiums compared to Treasury bonds, the rally may have more room to go as new deals price at such attractive yields.