Buyout Risk Back in the Corporate Bond Market

Low interest rates, and a search for earnings growth, are once again fueling the type of large buyout deals that were popular in the pre-financial crisis mid-2000’s. While these deals, which take public companies private, can be a boon to equity holders, they tend to be unfriendly to bondholders, as companies are saddled with debt financing. The latest example is Dell, where rumors of a buyout surfaced a few weeks ago and culminated in an announcement of plans for a $24.4 billion deal. Since details of the deal were leaked, Dell’s stock price has risen over 25%, while the company’s 10-year bonds outstanding have fallen by more than 10 points. A majority of the takeout will be financed with debt, increasing its leverage ratio (debt/EBITDA) from the 2x range to 6x and reducing Dell’s credit rating from the current A to a likely B, well within junk territory. Further, existing debt will likely be subordinate to new debt used in the takeover, further weakening the credit quality. All in all, being cognizant of privatization risk is paramount when investing in corporate bonds. We exited our investment in Dell bonds in 2011, as we felt the risk of a leveraged buyout was increasing. At the time, the bonds offered attractive yields relative to credit ratings, but not enough to compensate investors for privatization risk. We will continue to consider the merits of a takeover for all the corporates we own or consider adding, as the low rate environment increases the chances that more of these deals go through.