The LBO gamble

As Dell Inc. lays the groundwork for what could be a $20 billion leveraged buyout, the potential deal is raising a number of questions, from the depth of risk appetite for a transaction this size to whether LBOs even pay off in the long run. Dell will certainly serve as a litmus for the aspirations of other corporate dealmakers harboring similar ambitions. It will also be a test of the market's capacity to absorb a huge dollop of junk-rated debt, which is what Dell will certainly produce if its four bank underwriters succeed in placing a chunk of the $15 billion they are reportedly looking to underwrite and place.

That kind of debt will jack up Dell's leverage ratios big time. In a Jan. 17 report, Fitch Ratings said a buyout could push Dell's debt to 4.5 times Ebitda, which would make it the most-leveraged computer hardware maker in the U.S. All that debt -- which Fitch said could contribute to dragging Dell's rating to a junk-level B rating -- would hurt the tech company's ability to finance its expansion into Canada and Europe, the rating agency noted. "It would be impossible to finance this business at the corporate level with a sub-investment grade rating without third-party help," Fitch said.

In recent years, investors have tended to look askance at companies that have wanted to refinance old LBO debt with leverage ratios 5 times or higher, favoring ratios closer to 3 times. Such deals conjure the heady LBOs of 2006, the last time anyone tried to pull off a deal this big. In 2006, it was common to see transactions like the $33 billion HCA buyout, Harrah's Entertainment Inc.'s $27 billion deal and Clear Channel Communications' $25 billion deal. In 2006, if a company was a blue-chip name like Dell with decent turnaround prospects, lenders and investors were delighted to see the borrower buried in debt. After all, it added a nice boost to returns. Since then, many of those LBO names have struggled to repay maturing debt and have instead kicked the maturity can down the road.

Despite conflicting feelings investors have about highly leveraged deals, the bigger reality is that yield opportunities have been tough to find. Treasury yields are at rock-bottom lows while high-yield debt is now trading around 4% to 5% compared to a few years ago, when yields ranged closer to 11%. Those were the days when high-yield debt was, well, high yield. These days, everyone from distressed funds to pension funds are scratching around to meet their yield targets -- typically 7.5% or more -- which is one of the reasons bankers say Dell has a good shot at getting the deal over the finish line.

"Is the market there? The answer is yes," said Scott Humphrey, head of U.S. M&A at BMO Capital Markets Corp. in New York. "Treasuries are sitting at all-time lows. With the lowest risk returns at zero, this is pushing people off the cliff to take risk." The question is how much risk investors are willing to take or will be able to take if interest rates crank higher -- one of the biggest dangers for investors right now. At a recent Tabb Group LLC fixed-income conference, one speaker said the gap between risk and reward "is as wide as it's ever been." Another speaker suggested that investors in higher-risk assets could be in particular jeopardy if interest rates climb higher, given liquidity tends to dry up faster for riskier stuff when volatility soars and bondholders have already been poorly compensated. "For high-yield and distressed debt, the price gap will be enormous, like nothing we've ever seen," one speaker warned.

But all of that is in the future. If anything, some experts suggest that rather than expressing alarm at the growing risk-reward divide, investors may be revving up to take more risk. In a recent distressed debt survey, Macquarie Capital (USA) Inc. managing director David Miller said that while fund managers had apparently learned their lesson "regarding the potential dangers of high leverage multiples," he said it's less clear these investors "will continue to be happy with the safety lower leverage provides, even at the expense of increased returns."

That could be good news for Dell, although it may have to dodge another bullet in the form of concentration risk. "I would refer to this one as the pig in the python. By the time you get to the other side, you could soak up a lot of capacity in the market," Humphrey said. That may not be a problem for Dell, but it could be for other LBO candidates. Another question that won't be answered for some time is whether Dell will actually benefit from removing itself from the public sphere. Do LBOs really work, considering companies often get saddled with buckets of debt that can hurt their ability to finance growth through M&A and other tools? That tends to be tough to answer considering the general lack of research and data available on the performance of LBOs and reverse LBOs -- what happens once the company returns to the public market.

A recent report would suggest that an LBO might be just the fix that Dell needs, considering it has had a long stretch of underperformance and will need time to see payoff for some of the acquisitions and changes it has made. The report, produced by academics at Wayne State University and called "What Happens During the Private Period? Evidence from Public-to-Private Reverse LBOs," found that RBLOs make the companies in question more valuable once they've gone through the LBO process. And many, like Dell, start out undervalued. The report, published in Morgan Stanley's Journal of Applied Corporate Finance, found that the LBO process helped the 208 companies in the sample period spanning 1986 to 2006 "to observe changes in profitability, valuation, financial structure, operating structure, and cost structure" for the full period that was studied. Sudip Datta, an academic with Wayne State and one of the authors, said market caps in the sample ran as high as $34 billion and that some of the bigger names included RJR Nabisco, ConocoPhilips Co. and Safeway Stores. While smaller or mid-sized companies took an average of four years to re-emerge as public entities, it took more like six or so years for the biggest companies to turn around.

That might provide some inkling of what's ahead for Dell, should it manage to go private. Many believe it will take Dell five years to fully implement its business turnaround, whether it remains public or goes private. If it does go private, there's a general expectation it will eventually emerge as a public company down the road. Right now, though, six years sounds like another century in the world of M&A. The more immediate step for Dell is dressing itself up for a primetime LBO.