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February 22, 2011

Leveraged Finance:
Reshuffling The Debt: The Credit
Implications Of The New Wave Of
LBOs
Primary Credit Analyst:
Allyn Arden, CFA, New York (1) 212-438-7832; allyn_arden@standardandpoors.com
Secondary Credit Analysts:
William Wetreich, New York (1) 212-438-7869; william_wetreich@standardandpoors.com
Kenneth G Drucker, New York (1) 212-438-7831; ken_drucker@standardandpoors.com

Table Of Contents
The Mega Deals Of 2005-2007 Are Likely A Thing Of The Past
Where Are The 2005-2007 LBOs Now?
What Is Behind The LBO Resurgence?
The New LBOs: Transaction Size And Structures
Recent LBOs Have Not Caused Ratings To Fall As Precipitously As In
The 2005-2007 Period
We Expect More LBOs In 2011

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Leveraged Finance:
Reshuffling The Debt: The Credit Implications
Of The New Wave Of LBOs
(Editor's Note: This article is part of Standard & Poor's Ratings Services' "Reshuffling The Debt" series, which we
launched at the beginning of 2011. The series rekindles the "Leveraging Of America" series of articles that Standard
& Poor's published in 2007, which commented on the large increases in nonfinancial corporate issuers' debt
leverage shortly before the Great Recession began. "Reshuffling The Debt" investigates the leveraging trends of
these entities now that we are in the wake of the recession.)

Are we approaching another boom period for leveraged buyouts (LBOs)? Private equity firms have been completing
more of these deals since early 2010, bolstered by a modestly improving economy, healthier credit markets,
increasing appetite for risk among bond investors, and low interest rates. These companies have large amounts of
cash, possibly over $400 billion in total, and generally will need to invest much of it over the next few years.
Therefore, Standard & Poor's Ratings Services expects this pickup in LBO activity to continue in 2011. However,
we believe the days of mega LBOs--$10 billion to $15 billion in size or greater--will likely remain in the past, given
current market conditions.

The Mega Deals Of 2005-2007 Are Likely A Thing Of The Past


The surge in buyout activity during the boom period of 2005-2007 was the result of substantial inflows into private
equity funds, low interest rates, a robust collateralized loan obligation (CLO) market, and narrow spreads for
corporate--especially speculative-grade--debt. These factors encouraged increasing transaction sizes and allowed for
several large mega-cap deals, including the acquisitions of HCA Inc. for $34 billion in November 2006 by a private
equity consortium and First Data Corp. for $29 billion in September 2007 by Kohlberg Kravis & Roberts (KKR).
Such LBO giants carried greater debt burdens and significantly weaker credit protection measures than their
predecessors. Moreover, we originally rated several issuers around the middle of the credit spectrum ('BBB' to 'BB')
prior to their LBOs. Some examples included the buyout of Harrah's Entertainment Inc. (rated 'BBB-' with a
negative outlook prior to the announcement of the transaction) in January 2008, Univision Communications Inc.
(BBB-/Stable/--) in March 2007, and Freescale Semiconductor Inc. (BBB-/Stable/--) in December 2006. As a result,
the deterioration in credit measures and overall ratings was steeper than the declines caused by more recent LBOs.
Companies also structured debt transactions with weaker creditor protection, including "covenant-lite" loans and
payment-in-kind (PIK) toggle notes, where borrowers can make interest payments with cash or additional debt.
These measures, however, did provide additional structural flexibility, which, to some extent, eased the pressure on
credit quality from the ensuing Great Recession and poor credit market conditions.

There are some important distinctions that have characterized the recent wave of LBOs compared to the one that
took place a few years ago:

• Smaller transaction sizes;


• Lower debt burdens and better credit measures;
• Fewer structures with weak creditor protection provisions;
• Higher equity participation;

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Leveraged Finance: Reshuffling The Debt: The Credit Implications Of The New Wave Of LBOs

• Less liquidity from structured vehicles, such as CLOs; and


• Successful target companies have been non-investment grade, so there is less ratings impact from the LBOs than
on investment-grade targets.

Nevertheless, Standard & Poor's believes that a low interest rate environment, strong credit markets, large cash
positions held by private equity investors, and an increasing appetite for risk will result in an ongoing flow of LBO
deals. We also expect these transactions will have somewhat greater debt burdens and weaker credit measures going
forward, although it is unlikely that we will experience a resurgence of the mega LBOs that occurred from 2005 to
2007, given current credit market conditions.

Despite current robust high-yield bond and syndicated loan markets, the CLO market has dramatically shrunk from
peak levels. Moreover, Standard & Poor's believes that more stringent banking regulations, in their various forms,
will lead to higher capital requirements and more refined leverage constraints at banks. This will make it difficult for
banks and CLOs to fuel a substantial surge in LBOs.

Where Are The 2005-2007 LBOs Now?


From 2005 to 2007, we witnessed some of the largest LBOs in history, with several transactions exceeding $20
billion. There were only a few success stories, including ALLTEL Corp., which Cellco Partnership (d/b/a Verizon
Wireless) purchased only seven months after the completion of the LBO transaction was completed in November
2007. We downgraded discount retailer Dollar General Corp. to 'B' with a stable outlook from 'BBB-' with a
negative outlook following its acquisition by KKR for about $7.5 billion in July 2007. However, credit quality
improved over time due to strong operating performance from the company's value proposition during difficult
economic times. We later raised the rating to 'BB-' following the successful completion of the company's IPO. We
raised the rating again in June 2010, and it now stands at 'BB' with a stable outlook.

Most of the other LBOs of this period did not fare as well. Companies such as Tribune Co. and Station Casinos Inc.
filed for Chapter 11 bankruptcy in December 2008 and July 2009, respectively. Realogy Corp., a residential real
estate franchisor, fell on hard times due to a declining real estate industry and an overleveraged balance sheet. We
initially lowered the corporate credit rating to 'B+' from 'BBB' (both with a negative outlook) when the LBO
transaction was completed in April 2007. We currently rate Realogy 'CCC' because of the company's thin interest
coverage of 1x.

Freescale Semiconductor (B-/Watch Pos/--) suffered from its high customer concentration with a cell phone
manufacturer and the auto industry's steep decline. We lowered our rating on the company to 'BB-' with a negative
outlook from 'BBB-' after the transaction closed. The current rating largely reflects its elevated leverage of about 8x
and its exposure to the now improved, but still below peak, auto industry, along with its recent IPO filing.

Table 1
Examples Of LBO Rating Migrations (2005-2007 LBO Deals)
Post-LBO
Transaction Pre-LBO Post-LBO Rating adjusted Current
Company size (bil. $) Sector rating/outlook rating/outlook differential leverage rating/outlook
Energy Future 44.5 Utilities BBB-/Negative B-/Stable 6 notches -- CCC+/Negative
Holdings Corp.
HCA Inc. 33.8 Health Care BB+/Stable B+/Negative 3 notches 7.0x B+/Stable

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Table 1
Examples Of LBO Rating Migrations (2005-2007 LBO Deals) (cont.)
First Data Corp. 28.7 High Tech A/Stable B+/Negative 8 notches 9.0x B/Stable
Harrah's 27.8 Hotels & BBB-/Negative B+/Stable 5 notches 9.5x B-/Stable
Entertainment Inc.* Gaming
ALLTEL Corp. 27.0 Telecom A-/Watch Neg B+/Negative 7 notches 10.0x NR
CC Media Holdings 24.5 Media BBB-/Negative B/Stable 3 notches 10.0x CCC+/Positive
Inc. (Clear Channel)
Knight Inc.¶ 21.0 Energy BBB/Stable BB-/Stable 4 notches -- BB/Stable
Freescale 18.4 High Tech BBB-/Stable BB-/Negative 3 notches 5.6x B-/Watch Pos
Semiconductor Inc.
Intelsat Ltd.§ 16.4 Telecom BB-/Stable B/Stable 2 notches 9.1x B/Stable
Tribune Co. 14.5 Hotels & BBB-/Negative B/Negative 5 notches 9.5x NR
Gaming
Univision 13.7 Media BBB-/Stable B/Negative 5 notches 12.0x B/Stable
Communications Inc.
SunGard Data 11.5 High Tech BBB+/Watch Neg B+/Stable 6 notches 7.0x B+/Stable
Systems Inc.
Realogy Corp. 9.3 Hotels & BBB/Negative B+/Negative 5 notches 10.0x CCC/Positive
Gaming
Station Casinos Inc. 8.8 Hotels & BB-/Watch Neg B+/Negative 1 notch 10.0x NR
Gaming
ARAMARK Corp. 8.1 Consumer BBB-/Stable B+/Negative 4 notches 7.0x B+/Stable
Prods
Dollar General Corp. 7.2 Retail BBB-/Negative B/Negative 5 notches 8.0x BB/Stable
Neiman Marcus 5.3 Retail BBB/Watch Neg B+/Stable 5 notches 6.5x B/Stable
Group Inc. (The)
Average 18.9 8.7x
*Now known as Caesar's Entertainment Corp. ¶Now known as Kinder Morgan Inc. §Now known as Intelsat Global S.A. NR--Not rated.

What Is Behind The LBO Resurgence?


In 2010, LBO transactions totaled $79 billion, compared to only $13 billion in 2009, though still substantially
lower than the $434 billion of LBO deals recorded in 2007, the peak year of take-private activity. We believe several
factors are propelling this new wave of LBO transactions. Private equity firms are flush with cash from institutional
investors and they need to place this capital relatively quickly, as they often have up to six years to invest the funds
raised or release investors from their capital commitments. Moreover, valuations remain attractive relative to
historical trends. Following the 2008-2009 credit crisis, many of the 2010 transactions involved greater equity
participation and lower valuations, resulting in less leverage, which made them more attractive to investors and
banks. In fact, equity contribution in LBO transactions averaged about 41% in 2010, versus 31% in 2007.
However, some new deals in 2011 feature somewhat less equity cushion, including the $5.3 billion acquisition of
Del Monte Foods Co. by a consortium of private equity firms led by KKR. We expect this transaction to have a
32% equity cushion.

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Other factors contributing to the increase in LBO activity, we believe, are low interest rates and healthier credit
markets. These factors, coupled with improving corporate earnings and stronger credit profiles, have resulted in
tighter spreads for corporate debt issuance relative to 2009. According to Standard & Poor's Leveraged
Commentary & Data (LCD), the average institutional LBO loan spread was 462 basis points over LIBOR in 2010.
While spreads have tightened from very high levels in 2009, we note that they are still above recent historical trends
and could improve over the next year, especially if credit conditions remain healthy. Additionally, lender demand for
corporate debt is robust, and oversubscription of deals has often led to a flex-down in pricing for recent deals from
initial levels. Tightening spreads for corporate debt, combined with the recent declines in equity contribution from
peak levels, could potentially result in higher leverage and larger transaction sizes for future LBO deals.

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Still, we have seen a few instances where proposed large LBOs have fallen through. One example was the proposed
$7 billion buyout of hard-disk drive manufacturer Seagate Technology (BB+/Watch Neg/--) in October 2010.
According to LCD reports, the company decided to terminate discussions because the valuation was not attractive or
in its shareholders' best interests. However, Seagate remains on CreditWatch as we assess its future financial policy.
Another large LBO transaction that was not completed was the proposed $15 billion acquisition of U.S. banking
and payments technology provider Fidelity National Information Services Inc. (BB/Stable/--) in May 2010 by a
private equity consortium led by the Blackstone Group, also reportedly because of a disagreement on valuation. This
transaction would have represented the largest LBO deal since the 2008 financial crisis. Instead, the company ended
up pursuing a leveraged share repurchase program that resulted in a one-notch downgrade.

The New LBOs: Transaction Size And Structures


While the number of LBOs increased in 2010, transaction sizes were significantly smaller, with few deals exceeding
$5 billion in total value. The average LBO size was $1.0 billion in 2010, compared to $2.1 billion in 2007, but it is

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still higher than the 15-year average of around $800 million. Moreover, overall credit protection measures
associated with LBO deals are healthier than in the 2005-2007 period, and we saw fewer instances of weak creditor
protection provisions, such as covenant-lite loans and PIK toggle notes. According to LCD, average pro forma debt
leverage (total debt to EBITDA) was around 4.8x (not including Standard & Poor's adjustments) in 2010, compared
to 6.1x in the peak year of 2007. Moreover, credit measures are also comparable with the average over the past
decade.

Nevertheless, Standard & Poor's believes that new take-private deals could have increasing levels of debt, reduced
equity participation, and weaker credit protection measures over the next year. In fact, some of the recently
launched LBO transactions have carried more aggressive capital structures. For example, pro forma unadjusted
leverage for the recent Del Monte Foods Co. LBO is 6.7x (6.8x adjusted), while leverage for the Burger King Corp.
take-private acquisition was 5.9x (6.8x adjusted). Additionally, we have started to see a resurgence of less
credit-friendly trends, such as with the CommScope Inc. (B+/Negative/--) and Gymboree Corp. (B+/Stable/--) LBOs,
both of which had covenant-lite term loans. Other LBO deals, such as Del Monte and J. Crew Group Inc.
(B/Stable/--), also included term loans with weaker protective covenants.

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Recent LBOs Have Not Caused Ratings To Fall As Precipitously As In The


2005-2007 Period
Of the 2010 and early-2011 large LBOs that Standard & Poor's rated, five transactions resulted in a downgrade of
two notches or more, while four of these deals did not affect the ratings at all. The multi-notch downgrades included
J. Crew, Burger King, and Del Monte. All three credits were in the 'BB' rating category prior to the LBO
announcement. Meanwhile, 15 of the 17 largest LBOs during the 2005-2007 period suffered downgrades of three
notches or more, and many of them were originally low-investment-grade companies (in the 'BBB' rating category).
Additionally, retail and consumer product companies have been prime targets of private equity investors recently,
most likely because valuations have been attractive since the recession, despite the economic sensitivity of
companies.

Table 2
Examples Of LBO Migrations (2010 And 2011 LBO Deals)
Transaction size Pre-LBO Post-LBO Rating Post-LBO
Company (bil. $) Sector rating/outlook rating/outlook* differential leverage
Del Monte Foods Co. 5.3 Consumer BB/Stable B+/Stable 2 notches 6.8x
Prods
IMS Health Inc. 5.2 Health Care NR BB-/Stable N/A 5.1x
Burger King Corp. 4.0 Retail BB-/Stable B/Stable 2 notches 6.8x
NBTY Inc. 4.0 Consumer BB/Positive B+/Stable 2 notches 5.4x
Prods
EXCO Resources Inc. 4.0 Oil & Gas BB-/Stable TBD TBD TBD
CommScope Inc. 3.9 High Tech BB-/Positive B+/Negative 1 notch 5.7x
Interactive Data Corp. 3.7 Media NR B/Stable N/A 7.5x
J. Crew Group Inc. 3.0 Retail BB+/Stable B/Stable 4 notches 6.7x
Syniverse Holdings Inc. 2.6 Telecom BB-/Stable B+/Stable 1 notch 5.9x
Advantage Sales & 2.0 Retail NR B+/Stable N/A 6.8x
Marketing Inc.
Gymboree Corp. (The) 1.8 Retail NR B+/Stable N/A 6.1x
Michael Foods Inc. 1.7 Consumer B+/Stable B+/Negative 0 notches 5.8x
Prods
TASC Inc. 1.6 High Tech NR B+/Stable N/A 6.2x
Jo-Ann Stores Inc. 1.6 Retail BB-/Stable TBD TBD TBD
CKE Restaurants Inc. 0.9 Retail BB-/Stable B/Stable 2 notches 5.8x
BWAY Holding Co. 0.9 Packaging B+/Positive B+/Negative 0 notches 5.4x
HGI Holding Inc. 0.9 Health Care B/Stable B/Stable 0 notches 5.5x
Dave & Buster's Inc. 0.6 Retail B/Stable B/Stable 0 notches 6.4x
Average 2.6 6.1x
*Ratings on some of these entities may have changed subsequent to their LBOs. NR--Not rated. N/A--Not applicable. TBD--To be determined.

In our view, the recent LBO deals have not resulted in more material downgrades because:

• Most of the recent LBO targets were initially in the 'B' or 'BB' categories, whereas the earlier wave of large LBOs
included a number of investment-grade credits.
• Private equity sponsors have contributed more equity, and valuations are more reasonable. As a result, recent

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LBO transactions have had stronger credit measures than the ones during the 2005-2007 period. The average
leverage (including Standard & Poor's adjustments) for some of the largest rated LBO deals was about 6x, versus
9x for earlier large deals (see tables 1 and 2).
• In some cases, our rating prior to the LBO transaction already anticipated a potential increase in leverage.

We Expect More LBOs In 2011


We expect the LBO resurgence to continue in 2011, assuming that the credit markets remain healthy. Are the
markets suffering from "credit amnesia" or will there be some resistance by banks and investors as new deals come
to market? Private equity firms still have strong cash balances, which they need to invest sooner rather than later.
And companies are making deals with greater debt components, enhancing their appeal to private equity investors.
According to LCD, the average leverage multiple of large LBOs (those with more than $50 million of annual
EBITDA) was over 5x in December 2010 and January 2011--higher than the average LBO leverage for all of 2010
and above the norm for the past decade. The environment is currently favorable for more LBOs, although we do not
presently expect a return to the mega deals of the recent past. In an evaluation of some of these mega LBOs, we
believe that only a handful performed well from a credit perspective. As a result, we believe debt and private equity
investors will be wary of excessive leverage and large transaction sizes, and the significant equity investment
required. Additionally, the CLO market no longer provides as meaningful a source of liquidity to fund mega-LBO
deals. A more likely scenario is that LBOs continue over the coming year at an active pace, but are structured with
only modestly higher leverage than in 2010, with less equity cushion and fewer creditor protection provisions.

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