The possibility of a US-led leveraged buy-out for GEC Plc was canvassed in Sunday’s Observer, the belief that such a move was on the cards being spurred by persistent buying of GEC’s shares on Wall Street last week. The paper suggested that any US move for the company would have to be accompanied by a UK partner ready to step in and buy key parts of the business, with STC Plc perhaps the first name to spring to mind, although Hanson Plc and BET Plc are possibilities. The reason that big UK companies are now seen as appropriate targets for leveraged buyouts is that there are enormous amounts of cash piled up in US buy-out funds, and predators are running out of suitable US candidates – large, diversified companies with a strong and dependable cash flow. The main objection to such a move, apart from the obvious question of who would dare to brave the steely wrath of Lord Weinstock by attempting such lese majeste, is that, coming now, a leveraged buy-out would be timed to coincide with the moment when the whole concept of issuing vast amounts of junk bonds to refinance companies acquired in leveraged buyouts is being widely questioned back home where it began, on Wall Street. Former US Treasury Secretary James Baker was in London last week expressing grave worries that the whole leveraged buyout mania would end in tears, pointing out that many of the prospectuses issued for US ones seem to assume 10 years of growth uninterrupted by any taint of recession. Baker fears that if one of these hugely-indebted companies were to fail, the trigger effect could lead to a whole string of similarly over-borrowed companies collapsing. The first question that springs to mind is just who is it who is prepared to buy the junk bonds that pay a very high rate of interest – 14% and up – in recognition that they carry a high risk, issued by companies that are bought out and taken private? The answer to that appears to a substantial extent to be savings & loan associations, the US equivalent of building societies. The house mortgage busines has always flouted the conventions of sound banking by borrowing short and lending long, and in the US, the problem is compounded by the fact many mortgages are granted on a rate of interest fixed for the life of the contract – a great deal if you are able to take out a mortgage when interest rates are depressed, lousy if you take it out at the top of an interest rate spiral. It seems that in 1979, savings & loans were caught on the hop by a steep rise in interest rates, and found that they were having to pay out substantially more to secure deposits than they were receiving in mortgage interest repayments. To meet the shortfall, it became a matter of never mind the quality, feel the interest rate on their investments (CI No 570), and the junk bond, born a short time later, arrived at a time when savings & loans were desperate for such an instrument to keep themselves solvent. Why is Wall Street now suddenly getting spooked about the level of leverage in corporate America? The short answer is contained in yesterday’s front page lead story – that the signs of impending recession are unmistakable, and many leveraged deals have been calculated on a worst case scenario that no longer looks as if it took into account all the risks that attend over-borrowed companies in a recession.
Massaging recession into depression Why is James Baker so worried about just one big leveraged company collapsing? Why should that bring the whole edifice crashing? There are several inter-related answers, the most important one being that junk bond financing is only a part of the typical leveraged buy-out package. Another part is a very substantial proportion of the whole buy-out sum being met by straight bank loans – and bank loans can be called in at any time. A major crash would cause banks to look very closely at their loan portfolios and likely foreclose on the companies about which they were most concerned – typically other over-borrowed firms. At the same time, the value of the junk bonds held by savings & loans would slu
mp, and the effect on their capital ratios would likely render many of them insolvent, leading to a domino effect on other financial institutions, loss of confidence throughout the US economy and massaging of recession into depression.
We canvassed the idea of a leveraged buy-out for IBM the other day and explained why it wasn’t going to happen (CI No 1,044), but the idea has also occurred to US newsletter editor James Grant, who according to Saturday’s New York Times has even gone so far as to put together a 14-page prospectus for the buy-out just to underline how crazy the whole business has become. His plan would leave IBM with $12,400m annual interest payments, to be met by cutting research, ending the no-lay-offs policy and killing some products.