TwentyFour Asset Management
At this late point in the cycle, fixed income investors are on high alert for signs of potential excess in the capital markets, and a proposal for potentially the biggest leveraged buyout (LBO) in history would certainly fall into that category.
At a time when a globally coordinated economic slowdown remains a concern, more recently we have seen signs that the rate of slowdown is declining. However, as Federal Reserve Chairman Jerome Powell stated in his testimony to Congress this week, a period of lower rates and slower growth is the “new normal”.
US bond issuers have not been shy to tap the primary markets to take advantage of this environment. Year-to-date issuance in the US high yield primary market is over $230bn, according to figures from JP Morgan, already 23% up on the full-year figure for 2018. Of the 2019 HY issuance, around 68% has been refinancing and 20% acquisition or LBO related. Issuance in the US investment grade primary market is running at $1.1tr YTD, only 3% down on the equivalent 2018 figure, with around 37% refinancing related and 18% tied to acquisitions or LBO financing.
This week there was speculation that drugstore giant Walgreens Boots Alliance received a formal proposal from private equity group KKR for a take-private deal that could potentially require over $50bn of new debt. Depending on its ultimate structure, the deal would likely eclipse the 2007 LBO of energy company TXU Corp., which for many became a hallmark of the pre-crisis buyout boom when it filed for bankruptcy in 2014.
An LBO-style transaction would substantially increase leverage at Baa2/BBB rated Walgreens, meaning we would expect supply – again, depending on the structure – to come in both high yield and investment grade format, across loans, secured bonds and unsecured debt. Given the global nature of Walgreens’ business, we would also expect to see issuance across euros, dollars and sterling, with the latter aided by prevalence of the Boot’s chain in the UK. Existing Walgreens bondholders will no doubt be keeping a close eye on the situation, since given the increased leverage, a downgrade of the company to high yield – and a likely material associated move in bond prices – cannot be ruled out.
The financing mix would ultimately depend upon the amount of equity invested by KKR and any other potential partners. Given the size of the US IG market, where volumes dwarf those in high yield, we believe a high proportion of the deal would need to be targeted at IG investors. Issuing secured debt to ensure IG ratings would be one option available to increase the portion of financing coming from the IG investor base; Dell’s $67bn takeover of EMC and Charter’s $78.7bn takeover of Time Warner Cable are two recent examples of mega acquisitions that leaned heavily on the IG market, and both involved issuance of secured debt.
Powell’s “new normal” of low interest rates and slower growth should provide a good foundation for fixed income investors. Given the backdrop of accommodative central bank policy globally and all other things considered, we would anticipate a deal would be able to get done. The majority of the transaction would need to come into the investment grade arena, and anywhere between $10bn and $15bn in global high yield wouldn’t be beyond the realm of possibility.
In any case, given its strong free cash flows, we believe Walgreens makes a good LBO candidate. If anything, history has taught us that late cycle M&A can be difficult. Whether this is a prescription for success remains to be seen.