Looming Wave of Maturing Debt

The Wall Street Journal recently reported on more than $550 billion in debt taken on by European companies acquired in leveraged buyouts which will be reaching maturity within the next five years.

This massive wave of approaching debt repayment obligations is a significant issue for a number of reasons. The PE firms backing many of these highly-leveraged companies have been grappling with the task of adding value in the throes a challenging economic environment, as well as with a reduced ability to exit via secondary deals and IPOs.

In the U.S. we haven't yet experienced the same types of debt problems because of the appetite for high yield bonds in this country. The buyout peak of 2007, which saw nearly $1.6T in deal volume by middle of that year in the U.S. alone, also spurred the creation of a lot of debt in PE-backed companies. We are beginning to see the maturity of that debt. Again, the problem here is that many of those companies haven't grown in the way they were expected thanks largely to a battered global economic landscape. The fallout in the U.S. is a trend of PE companies buying themselves more time on their obligations by refinancing. And these companies are avoiding exorbitant interest expenses in a high yield debt market which, fortuitously, is experiencing low premiums. Last year, KKR alone extended or refinanced nearly $60 billion of debt for its portfolio companies.

But banks across the pond are wary of refinancing the half-trillion in burdens coming due over there, and there is no robust debt market, as in the U.S., which is helping to alleviate the situation. Clearly, all of this debt crashing down at once will lead to a lot of scrambling and, most likely, a lot of restructuring. To exacerbate matters, some analysts are forecasting a growing and sustained debt aversion scenario, even here in the U.S.

This situation, as with any, cuts both ways. The multitude of steeply-leveraged companies and those with meager earnings will continue to struggle to find financing opportunities. And this is could very likely spell the end for many of the zombie companies which have been hobbling along for the past several years. The upside may come for those who will be splitting up the remains.

Specialty sector focused private equity with flexibility and cash position will do well as credit dries up and an acquisition environment looms. And unique funds will have the opportunity to contribute to the type of reorganization that can allow the true economic therapy to begin - putting an end to the zombies and building real commercial and investor value going forward.

Even Warren Buffet likes the "business of chemistry" ….another stamp of approval for chemical industry thorough acquisition of Lubrizol

During the last few years, Berkshire Hathaway Inc. has made many investments in chemical and chemistry related businesses such as Nalco, Dow (Rohm and Haas), Great Lakes Chemical (GLK), Kaiser Aluminium & Chemical Corp. Sealed Air Corp, GSK, J&J etc. along with some petrochemical companies like ExxonMobile, ConocoPhillips, PetroChina and so on. Mr. Buffet’s notable commitment to the chemical industry is illustrated thorough Monday's announcement to purchase Lubrizol (LZ) for $135 a share, 28% above Friday's closing price! The consummate value investor, Mr. Buffet is expected to pay $9.7bn (which includes $700m in net debt) for the transaction. Even after paying a $30 premium (i.e. 28%) over the $105 closing price on Friday, Lubrizol transaction is priced at approximately, 7x 2011’s EBITDA and 5.4x 2012’s EBITDA.

Now if you consider today’s availability of cheap money in the capital structure, the WACC is no more than 8.5% (assuming at least 2x interest coverage with a realistic leverage 4.7x - 5x), Mr. Buffet is expected to generate top quartile returns (with a minimum Internal Rate of Return (IRR) percentage in the 20s within 3-5 years!).

We can talk all day long about the public market anomalies, various deal dynamics, and business related topics such as sustainability of margins in the lubricant additives value chain or excessive swings of commodity feed stocks (e.g. energy price, oil and petroleum derivatives). However, a company’s success will continue to depend on the management’s ability to control risk and take advantage of perceived market risks. For example, Lubrizol is a well managed company that poses an excellent profile of a “very good” specialty chemical company, growing its revenue consistently (for example: $3.4B in 2004; $5.4 in 2010), generating very strong cash flows and returns on capital, displaying a strong balance-sheet and flush with cash. We should also realize that Lubrizol has been increasing earnings at a compounded growth rate of 16% (at least for last 10 years; and Lubrizol's earnings growth has accelerated to over 25% per annum during the last 5 years).

Lubrizol continues to maintain its specialty status in a “so called commodity risk” environment by focusing on: its proprietary product (not necessarily patent protected product), mastering its product application for their customers’ system/process, delivering process/system monitoring services and maintaining overall strategic focus etc. (note: Relatively speaking, Lubrizol is neither capital intensive nor over reliant on R&D expenditure). Ultimately, Lubrizol’s strong performance over the years coupled with an excellent new owner should position Lubrizol to be even more successful as it moves forward. What are your thoughts?