High debt in proposed deal for electronics retailer
FORTUNE – Analysts’ reaction to the bid to buy Best Buy (BBY) from the company’s former chairman was this: Not going to happen. They said private equity investors would balk at the amount of debt Richard Schulze would need to raise to make the deal fly. “This would be a very hard deal to pull off,” says Michael Pachter, who follows Best Buy for Wedbush Securities.
But if recent deals are any guide, Schulze’s bid to take back the company he founded may have a better shot than some guess. The leverage well for private equity deals, which dried up in the financial crisis, appears to ready to draw from again.
In the second quarter, private equity firms used debt to pay for 64% of the average large company buyout deal, according to S&P Capital IQ. That’s the highest that figure has been since the start of the financial crisis.
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And while that’s down from where it was in 2005 and 2006, when debt averaged around 70%, some deals appear to be approaching pre-crisis levels. For example, private equity firms Carlyle and BC Partners plan to finance their recent $3.5 billion purchase of the industrial divisions of United Technologies unit Hamilton Sundstrand with two-thirds debt, said one banker with knowledge of the deal.
One reason leverage is creeping up again is because debt remains cheap. Low interest rates have caused banks and investors to seek out higher yielding investments. That’s made it easier for private equity firms to get financing at better prices. It has also opened the door for so-called covenant-lite deals in which banks lend money with few strings attached. Those types of loans now make up 21% of syndicated bank lending, up from just 5% two years ago.
This is, of course, good news for private equity firms looking to do deals and boost returns. For the banks, it could be a different story. And some worry that the rush to finance these deals could fuel a new private equity bubble, and debt crisis.
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For now, though, those fears seem overblown. That’s because LBO prices are down 20% from 3 years ago. As a result, even with the higher debt, most deals still seem less risky than those being struck just a few years ago. The debt-to-ebitda ratio (a measure of leverage to a company’s cashflow) of the average private equity deal in the first half of 2012 was 4.85. Back in 2007, leverage ratios were north of 6.
On Monday, Schulze said he was assembling a group that would pay $24 to $26 a share for Best Buy, or roughly $8.8 billion. As part of the deal, Schulze said he would contribute his stock, which is worth roughly $1 billion. Analysts said Schulze and other private equity investors are likely to invest another $2 billion. That leaves $5.8 billion to financed by debt, or nearly 66%, which is similar to the Hamilton Sunstrand deal.
The deal’s leverage would be on top of the $1.7 billion in long-term debt that Best Buy already had on its books. Add that in and the deal has a debt-to-ebitda ratio of 3.2, which looks cheap. That, though, is based on Best Buy being able to maintain it’s cashflow, which appears to be shrinking. But at a time when banks are rushing to finance deals, it’s not clear that concerns like that matter.
