Behind Buyout Surge, A Debt Market Booms

http://online.wsj.com/article/SB118282461107748034.html?mod=hps_us_pageone The corporate buyout boom of the 1980s was funded in large part by high-yield "junk" bonds. This time around, another financial product is supplying much of the fuel -- collateralized loan obligations. CLOs, as they're called, are giant pools of bank loans bundled together by Wall Street and sold off to investors in slices. They aim to spread default risk an inch deep and a mile wide. Last year, more than half of the loans behind the record wave of buyouts were parceled out to investors as CLOs, bankers say. As corporate borrowing soars, however, concerns are growing that CLOs have made it too easy for shaky or debt-laden companies to borrow money. If economic conditions deteriorate, those loans could sour and investors in the riskiest CLO slices could face large losses. That, in turn, could make it harder for buyout firms to borrow money. An index tied to non-investment-grade corporate loans fell all last week, according to Markit Group, its administrator. The index, LCDX, was launched one month ago and reached its lowest point yesterday. In late April, a Bank of England report noted parallels between the markets for subprime mortgages and for poorly rated corporate credit, heightening concern about the CLO market. CLOs are a form of collateralized debt obligation, or CDO. Besides corporate loans, CDOs often hold mortgage bonds and junk bonds. Borrowing by corporations has soared in recent years, and CLOs have played a big part. Since 2004, more than $210 billion of loans have been packaged into CLOs, up from $51 billion over the prior four years, according to data provider Dealogic. Investors searching for higher yields have put so much money into CLOs that even weak companies can get loans at relatively low interest rates. Last winter, for example, ailing Ford Motor Co. was able to borrow $23 billion in a matter of days, $5 billion more than it earlier planned. If loans in such pools go bad, the losses are initially borne by investors holding so-called first-loss tranches, which carry no credit ratings. Modest changes in loan defaults or even changes in market perceptions can lead to big swings in the value and yields of these securities. In exchange for bearing that risk, those investors stand to earn higher returns. Over the past two years, those tranches have returned more than 20% annually, according to Moody's Investors Service. Risk-averse investors can buy the more secure pieces, which carry investment-grade ratings, many of them comparable to the top ratings of U.S. Treasurys. Consequently, the yields on those slices are lower. These days, banks that arrange large buyout financings hold on to very little of the loans themselves. Bank underwriting standards have slipped as banks have become mere intermediaries, some executives at buyout firms contend. Banks enable and encourage private-equity firms to load up their companies with debt, these executives say. Most of the loan pieces ranged in size from $500,000 to $4 million. The CLO bought a portion of $1.8 billion in loans to Nasdaq Stock Market Inc., which the stock exchange had used to acquire a minority stake in London Stock Exchange Group PLC last year. It also bought pieces of loans that financed the buyouts of Neiman Marcus Group Inc., HCA Inc., Sungard Data Systems Inc. and Petco Animal Supplies Inc. Nearly all of the loans carry credit ratings that are below investment-grade, or "junk." The CLOs offered floating interest rates, which meant they would yield more if interest rates rose. CLOs have been lauded by former Federal Reserve chairman Alan Greenspan and others for dispersing risk. Michael Milken, whose underwriting of junk bonds at Drexel Burnham Lambert Inc. during the 1980s ignited that decade's buyout boom, has said that CLOs are among the most important financial innovations of the past quarter century. Over the past few years, buyout deals have been getting larger and larger, and companies have been piling on more debt in relation to the cash they generate. That leaves them especially vulnerable to rising interest rates and a slowdown in economic growth. The buyout of Univision Communications Inc. by a consortium of investors earlier this year, for example, left the broadcast company with a debt level of 12 times its annual cash flow, twice the norm in buyouts done over the past two years, according to Standard & Poor's. It's possible that even a small increase in defaults could have a big impact on CLOs, especially on the first-loss tranches. If investor appetite for these risky pieces diminishes, it could become harder for new CLOs to be issued, potentially choking off the buyout boom.