The hit list

Can you say schadenfreude? There's been no shortage of gloating at private equity's comeuppance over the past year. The Masters of the Universe are sidelined by the credit crisis and even blamed for it. They got carried away, bidding wildly at the peak, a view holds, and now they must pay the price.

To be sure, buyout firms have taken their lumps. Cerberus Capital Management LP is struggling to salvage something from its bets on Chrysler LLC and GMAC LLC. In September TPG Capital kissed goodbye the $1.3 billion it had invested in Washington Mutual Inc. just five months earlier when the savings and loan was seized by regulators. Dozens of sponsor-backed companies -- from cookie makers to airlines to jewelry chains -- have filed for bankruptcy. Some, like Univision Communications Inc., are scrambling to refinance maturing debt.

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Meanwhile, senior bank debt and bonds from many leveraged buyouts are trading at discounts to par of 25% or more. That implies that the equity in those deals is worthless. Moreover, valuations are down across the board. "Where the real value destruction is, is in the multiple side," one banker says.

With valuations so far down, says a second banker who works with buyout firms, "it's all about option value." The financing terms for megadeals were so liberal, he says, that the investments amount to options on the upside. "If you come through, these are such huge businesses that a positive swing could generate huge gains."

Whatever the "fair value" of these investments is now, in the middle of a meltdown, the largest deals -- the icons that defined the era -- are holding up surprisingly well on an operational basis, an analysis of the 10 biggest buyouts from 2006 and 2007 shows. A couple are struggling, but none appear to be in danger of defaulting, in part because of advantageous (read: lax) debt terms. Several, including U.K. drugstore chain and beauty products maker Alliance Boots plc and Hilton Hotels Corp., are performing outstandingly. A third, Alltel Corp., is about to be flipped at huge profit. TPG and Goldman Sachs Capital Partners may collect a $1.3 billion profit on their $4.53 billion equity investment when the Alltel sale to Verizon Wireless closes. Who says you can't buy at the top of the market, pay more than 10 times Ebitda and still make out like a bandit?

Is bigger better?
The buyouts that defined an era have defied predictions and performed surprisingly well as a group.
Target	Buyers	Closed	Report card	Deal value ($miil.)
Energy Future Holdings Corp. Utility (fka TXU Corp.)	Kohlberg Kravis Roberts & Co., TPG Capital	Oct. 10, 2007	KKR wrote up value 40% in the first half based on comps. Ebitda slid fractionally in first half, but company is seen as stable and debt trades reasonably well.	$43,800
HCA Inc. Hospital operator	Bain Capital LLC, KKR, Merrill Lynch Global Private Equity	Nov. 16, 2006	Value written up 20% at the end of 2007. Adjusted Ebitda fell 7% in the first half due largely to slower collections, but business is seen as stable and debt has been paid down.	32,670
Harrah's Entertainment Inc. Casino and hotel operator	Apollo Management LP, TPG	Jan. 28, 2008	Casino takes have been falling, dragging cash flows down, but company has $1.25 billion in cash and PIK note flexibility.	29,900
Alltel Corp. Wireless carrier	TPG, Goldman Sachs Capital Partners	Nov. 16, 2007	A quick flip. Verizon Wireless agreed in June to buy Alltel, promising huge gain for sponsors.	27,870
First Data Corp. Debit and credit card processor	KKR	Sept. 24, 2007	Revenue rose 13% in the first half, and costs are being rung out. Remains vulnerable to economic slowdown, however.	27,730
Hilton Hotels Corp. Hotel operator	Blackstone Group LP	Oct. 24, 2007	Ebitda grew at double-digit rates in the first half, driven by international business and franchising. Nevertheless, could be vulnerable if economy slows more.	26,930
Clear Channel Communications Inc. Radio broadcasting and billboards	Thomas H. Lee Partners LP, Bain Capital Partners LLC	July 30, 2008	Business slowed in first half before buyout closed. Company likely to face headwinds but has very flexible financing.	24,860
Knight Inc. Pipelines and energy storage (fka Kinder Morgan Inc.)	Goldman Sachs Capital Partners, American International Group Inc., Carlyle Group, Riverstone Holdings LLC	May 30, 2007	Distributable cash flow from the limited partnership Knight manages rose 37% in the first nine months of 2008 despite hurricane losses.	21,560
Alliance Boots GmbH Drug retailer and distributor	KKR	June 26, 2007	Revenue was up 6.3% in the year ended March 31, and Ebitda rose 18%, partly due to efficiency gains.	20,620
Freescale Semiconductor Inc. Specialized semiconductors	TPG, Blackstone, Permira Advisers LLP, Carlyle	Dec. 1, 2006	CEO was replaced and plants closed, but sales and Ebitda are up and company has $1.2 billion in cash. Cell phone chip unit was put on the block Oct. 2.	17,600
Deals announced in 2006 and 2007 that have closed. Real estate investment trusts excluded. Sources: Dealogic, company reports, The Deal

The top 10 haven't dodged the downturn entirely. Take Harrah's Entertainment Inc., the casino and hotel operator. Gambling was supposed to be recession-proof, but seemingly not this year. The $29.9 billion buyout got off to a rough start after it closed Jan. 28. Revenue fell 2.9% in the first half compared with the same period last year, and adjusted Ebitda fell 10.5%. Harrah's blamed that on high gas costs, falling net worths and Midwestern floods. In June, Apollo wrote down its $1.35 billion equity stake by 25%, according to filings by a publicly traded fund in Europe that it manages.

The falloff accelerated in the second quarter, and things have deteriorated since June. Total gaming revenue in Nevada, where Harrah's derives 33% of its revenue and 41% of its cash flow, fell 24% in July compared with last year, according to state gaming regulators, and were down 6% in August. Business was also lousy in Atlantic City, N.J., which provides a further 23% of Harrah's revenue. The year-to-date take at Harrah's five New Jersey casinos was down 5% through the end of September, according to figures from state regulators, and the drop was accelerating, with revenue falling 15% in September compared with last year. Harrah's 5.625% bonds due in 2015 have been trading under 80, and senior bank debt has been in the low 70s -- below the debt of healthier LBOs.

Harrah's was highly leveraged, with just $5.87 billion of equity, slightly less than 20% of the enterprise value. (Apollo, through three of its funds, put in just $1.35 billion, apparently syndicating the rest of its 50% stake. Blackstone Group LP bought a small slice of equity in the spring.)

Harrah's, however, is in no danger of defaulting. It had $1.25 billion of cash as of June 30, enough to cover interest expenses for six months. Moreover, it has pay-in-kind toggle notes, so it can opt to pay part of its debt in paper rather than cash if things get tighter. In the longer term, if gambling recovers, Harrah's is well positioned because it is more geographically diversified than many of its rivals and has a stable of strong brands, including Caesar's and Bally's. "The asset value is probably pretty good," says Moody's Investors Services senior vice president John Rogers, offering reassurance to debtholders if Harrah's can't ride out the downturn.

Clear Channel Communications Inc., the radio chain and billboard company, also could be dented by a slowdown because it is sensitive to advertising. The price was cut this spring after lenders balked at funding the original deal and the buyers, Thomas H. Lee Partners LP and Bain Capital Partners LLC, took the banks to court.

No figures have been released for the period since the deal closed July 28, but the trend lines were worrisome in the second quarter. Revenue was up 2%, but that included a 3% boost from foreign income taken in when the dollar was at its lowest and Clear Channel's Oibdan -- operating income before depreciation and amortization, noncash compensation, merger costs and gains on dispositions -- fell 7%. Oibdan in its radio division, which accounts for about 60% of cash flows, was down 10%.

The stub equity, traded over the counter under the name CC Media Holdings Inc., was in the dumps this month at $6.25, barely one-third of its $18.25 price when the deal closed three months earlier. But the company came out of the LBO with interest coverage of about 1.5, according to a Fitch Ratings report at the time, and projected free cash flow of $150 million. It could increase those cushions by exercising its right to pay part of its debt in kind, which would boost the latter by $150 million, Fitch said. The financing also included new debt committed in advance to replace pre-LBO debt that comes due in 2009 and 2010, so there's a lot of breathing room.

Clear Channel 5.5% bonds due 2014 are trading around 80 -- well above the worst LBO debt levels.

Two bankers who follow LBOs consider the Clear Channel buyout more of a stretch than most, but THL Partners co-president Scott Sperling argues that the price reflected expectations of a slowdown, as well as generous financing terms. "We never believed that we were forever upward," he said at a Corporate Dealmaker conference Oct. 2. "We believed we would have a serious recession sometime in the next five years, and probably in the first year or two. That was baked into the modeling we had done."

A third investment, the $18.8 billion buyout of Free­scale Semiconductor Inc., has had more than its share of bad press, but the situation is nowhere near as bad as a BusinessWeek cover story in April would have it ("When a Buyout Goes Bad"), which melodramatically declared that "few recent buyouts have been as disastrous as Freescale's." The sponsors -- Blackstone, TPG, Permira Advisers LLP and Carlyle Group -- had to replace the CEO, and the company has shuttered plants in Arizona and Scotland. On Oct. 2 Freescale said it would sell its cell phone chip unit, which accounts for 23% of revenue, or spin it off in a joint venture to achieve better scale.

Still, Freescale's numbers are solid. Sales have risen steadily and second-quarter Ebitda was up 15% over the first quarter and 26% over the prior year period, and the company had $1.2 billion of cash on its books as of June 30. Moody's downgraded Freescale from Ba3 to B1 last year when the company came in under projections, but Freescale is relatively lightly leveraged and the current B1 rating is stronger than many big buyouts.

The cell business had been the challenge all along because the bulk of Freescale's cell phone chip sales were to Motorola Inc., its former parent, which has been losing market share. The sponsors have said that they budgeted for declining sales to Motorola and that Freescale was protected by an agreement with Motorola that guaranteed minimum payments. (Freescale said Oct. 2 that it has reached an agreement for Motorola to get out of that pact in exchange for a payment.)

Selling the less profitable, capital-intensive cell chip business may give Freescale a boost. Commenting on the Oct. 2 announcement, Moody's said a sale would boost margins while reducing customer concentration and volatility, and it maintained its B1 corporate family rating. Freescale's 8.875% 2014 notes have traded at about 96.

SVG Capital plc, a publicly traded London fund that invests in Permira's buyout funds, has marked down its indirect stake in Freescale by 17.6%, and some of the sponsors' investors doubt it will ever be a home run. But Freescale is not at risk.

Perhaps the biggest surprise among the top 10 deals is how well Kohlberg Kravis Roberts & Co.'s are performing. Rivals grumbled last year that KKR was outbidding competitors by huge amounts. At points it seemed that KKR simply wanted to stake its claim as the dominant firm in megabuyouts, say both an executive at one rival and a banker who follows the industry. Some of the multiples were mind-boggling: Its deal for First Data Corp. worked out to be 16.1 times trailing Ebitda, and it offered almost 15 times for stereo equipment maker Harman International Industries Inc. before that deal crumbled. (KKR struck a settlement and took a minority stake.)

No one is laughing now. TXU Corp., now Energy Future Holdings Corp., at $43.8 billion the largest buyout ever closed, saw Ebitda fall 2.7% in the first half, but KKR marked up the value of the investment by 40% in the first half based on valuations of comparable public companies, according to filings by KKR Private Equity Investors LP, the Amsterdam-listed fund that is managed by KKR and invests in its funds.

Likewise, at the end of last year, KKR booked a 20% markup on hospital operator HCA Inc., which it bought for $32.7 billion in late 2006 with Bain Capital, Merrill Lynch & Co. and management. Explaining that boost, KKR PEI's year-end report cited "higher patient acuity levels" -- sicker patients, apparently -- and cost reductions. Results this year have been less promising. Revenue was up, but adjusted Ebitda fell 7% in the first half compared with 2007 mainly because of collection problems and growing numbers of uninsured patients in a slowing economy. Like Energy Future, the write-up of HCA may have to be reversed given stock prices of comparable companies. Still, admissions and revenue per patient were up, and adjusted Ebitda was twice HCA's interest costs. Proceeds from the sale of some hospitals have been used to pay down debt.

"Plus or minus 10 percent is fine," says Moody's Rogers, commenting on cash flow declines at TXU and HCA. "You're in a pretty stable industry" in both cases, he adds.

Alliance Boots, parent of the U.K. drugstore chain Boots and a major pharmaceutical distributor, meanwhile, soared after its $20.6 billion June 2007 buyout -- the largest ever in Europe. Revenue was up 4.8%, and Ebitda rose almost 18% in the year ended March 31. The deal came a year after the company was formed by a merger of the wholesale and retail businesses, leaving integration savings to be harvested. The company realized $117 million in cost savings in the 2007-2008 fiscal year, 60% of its long-term goal, leaving room for more bottom-line improvements. The conversion of 700 Alliance outlets to the better known Boots brand should help.

Meanwhile, another KKR retail-oriented holding, First Data, was expanding. Revenue was up 13% in the first half at the credit and debit transaction processor, boosted in part by several acquisitions. The company provides no fewer than three different forms of Ebitda, but the "consolidated Ebitda" of $3.05 billion used for purposes of its senior debt covenants is double First Data's interest expense. That includes $250 million of projected near-term cost savings, derived in part from consolidating data centers in the U.S. and abroad.

Whether the picture continues to be so rosy is an open question. "Anything that has any connection to retail is going to take it on the chin for the next few months," says one banker who works with buyout firms. But the lofty multiple KKR paid does not look so wild now.

The picture looks good for KKR, given that Alliance Boots, First Data and Energy Future are its three biggest investments: $2.5 billion of equity each for Alliance and First Data and $2 billion for Energy Future, according to the prospectus for KKR's pending initial public offering. KKR's purest retail play, discount retail chain Dollar General Corp., has seen sales rise more than 11% in the quarter ended Aug. 1, and adjusted Ebitda was up 55% from last year. "KKR paid a premium for some good companies," says a second banker, "which is OK."

At least as surprising as KKR's successes in retail-linked businesses is Blackstone's $26.9 billion buyout of Hilton, announced July 3, 2007, just as credit markets were cracking. Travel-related businesses tend to hurt when the economy slows, and other hotel chains have suffered this year. Hilton hasn't released financials since going private last October, but Blackstone says the company is bucking the trend and chalked up double-digit Ebitda growth in the first half.

For now, it looks like buyout jocks, having grabbed all that cheap debt while they could, can smile. At least for now.

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