Risks of private-equity buyout deals aren't always so private

NEW YORK » Next time a big private-equity deal is announced, don't assume it won't affect you. How those buyouts are being structured could reverberate across corporate America.

That's because the private-equity firms are piling debt on to the companies that they buy, and then often using the cash that the loans generate to enrich themselves rather than putting it toward improving the companies' financial health.

Things could get ugly should that debt grow too big for the companies to handle -- not so much for the buyout firms themselves, but for everyone else from workers to suppliers to banks with even the most remote ties to the companies.

It's something to watch for as the buyout business booms, with a total of $404 billion worth of deals done this year, double the pace seen a year ago, according to Dealogic. Among the big buyouts in recent months are hospital chain operator HCA Inc. and Spanish-language broadcaster Univision Communications Inc.

Private-equity firms used to buy a company, overhaul its operations, and then use the cash flow from its improved business to start paying down its debt. The big profits would then come from taking the companies public.

But a slow IPO market in 2002 and 2003 caused the buyout firms to rethink how to guarantee themselves fat payouts. That's when many started to increasingly use something called a dividend recapitalization, which meant the companies borrowed money that they mostly wouldn't use to invest in the business but to pay themselves back for their initial investment with a dividend.

The lower tax hit also made the issuance of dividends attractive. In 2003, the government cut the dividend tax rate to 15 percent, well below the capital gains tax on ordinary income of 35 percent.

Such benefits have turned cash-out borrowing into a regular practice. There has been more than $38 billion in dividend recaps so far this year, up from about $7.7 billion in 2004, according to Dealogic.

"It lets them recoup their investments, and then some," said Lehman Brothers accounting and tax analyst Robert Willens. "They can borrow money cheaply, and they put the onus on the lender."

While this is guaranteeing the private-equity firms cash in their pockets, the added debt means higher loan payments, which not every company will be able to manage. That's especially true in an environment of slowing economic growth and rising interest rates.

A new report from credit-rating agency Standard & Poor's tracked 52 debt deals between 1995 and 2003 that raised money to pay private-equity firms and found that about 6 percent of those loans ended up in default. That compares with a 3.7 percent default rate for all leveraged loans tracked by S&P's leveraged commentary and data group.

That's a big difference -- and what makes those findings worrisome is that it came even before the buyout firms really stepped up the number of dividend recaps that they were doing.

Consider the case of Nellson Nutraceutical Inc., which filed for Chapter 11 bankruptcy court protection in January. The maker of energy bars and health supplements was bought in 2002 by private-equity firm Fremont Partners in a $300 million debt-laden deal. It then took on $100 million in loans in 2004, which was largely used for a recapitalization.

"Fremont Partners is pleased to be able to provide our limited partners with substantial liquidity on their investment while continuing their full participation in the investment," Bill Lenihan, a managing director of Fremont Partners, said in a statement when the recapitalization was announced.

But while Fremont's team got its cash, Nellson's business soon started to crumble amid waning popularity of low-carbohydrate products as well as productivity issues that crimped its margins.

When it finally filed for bankruptcy, the company said it had $336 million in debt and $15.7 million in cash on hand. Its bankruptcy filing pegged the company's 2005 loss at $24 million, due in part to higher interest expense.

Fremont did not return a request for comment.

The private-equity firm Bain Capital bought KB Toys in 2000, and was subsequently sued by the toy chain's creditors -- which included toy manufacturers and landlords of its stores -- after KB filed for bankruptcy court protection in 2004. During those proceedings, KB's cost-cutting left the toy retailer with about 600 stores and around 7,500 employees, each about half of what KB had when it entered bankruptcy protection.

The lawsuit alleged that loans taken out by the company were used to pay Bain and KB executives a $121 million dividend when the company already was struggling to compete with the big discount chains like Wal-Mart Stores Inc. Bain has countered that KB Toys was in good financial shape when the dividend was paid. The case has not yet been resolved.

KB emerged from bankruptcy court protection last year, and has new owners.

Given how things can go, investors must beware. This really affects anyone who is interested in buying stock in companies backed by buyout firms that have recently gone public or are slated for IPOs. They should check out if such recaps are happening, and when -- the most troublesome are those that happened soon after the initial buyout.

S&P, in its study, points out that "dividend recap deals can unravel, despite the best-laid plans for their sponsors, if a company's business risk suddenly changes and it cannot afford the debt payments necessary to sustain the leverage it has incurred."

It also notes that the bank debt that funds the recaps can carry floating interest rates, which means companies could get stuck with higher interest bills should rates rise.

For most Americans, such dealings might seem like a world away. But when jobs get lost or stress is put on the banking system, it could certainly hit home.