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Where Have All the Raiders Gone?

Despite rock-bottom share prices -- and low borrowing rates -- LBOs are few and far in between. Plus: regulators looking at "pay-for-play" financing, and will pension plans get real?

1Nov

With share prices at stomach-wrenching lows and a reasonably healthy high-yield climate, market watchers are anxiously waiting to declare a return to the era of the corporate raider. But instead, leveraged-buyout players have been strangely slow on the draw, while their cash has been piling up, uninvested.

To be sure, some vulturelike investors have saddled up. At press time, The Carlyle Group and Welsh, Carson, Anderson & Stowe were arranging as much as $1 billion in high-yield financing to fund their $7+ billion purchase of Qwest's directory unit. Following a number of similar deals this fall, it's no surprise that some observers were predicting a stampede of buyouts.

But experts say a return to a buying frenzy like that of the late-1980s is unlikely. For one thing, the current limited buying may be due more to pressure from fund investors to spend than to good opportunities. Uninvested LBO capital crept up to $123 billion in 2001, according to research firm Venture Economics. "It's tough to justify the amount of money they've raised if they're not investing it," says Robert Dunn, associate editor at Private Equity Analyst newsletter.

Leveraged buyers are also facing less-favorable terms. LBO firms parted with equity worth an average 41 percent of the deal price in the third quarter, according to Standard & Poor's Portfolio Management Data. "It's the highest in recent memory," says PMD's Marc Auerbach. In the late 1980s, the average fell to 10 percent.

Patient investors say that it's a seller's market. "I am seeing very few bargains--quite the opposite," says Frederick Iseman, chairman of $2 billion fund Caxton-Iseman Capital Inc.

Banking: Another Nick in the Wall

Wall Street just can't seem to get out of its own way these days. Even as the scandal over the breakdown of the wall between research and investment banking continues to cast a dark cloud over large banks, another gathering storm threatens to further weaken their credibility.

This time it's the commercial lenders that stand accused. Regulators are looking into allegations that banks are making loans contingent upon the corporate borrower's ability to provide other fee-based business, such as cash-management services or investment banking. The illegal practice, known as "tying" or "pay to play," is said to be widespread among commercial banks.

The National Association of Securities Dealers launched an investigation into tying after it received complaints from corporate borrowers. Although NASD won't comment on the investigation, it did issue a notice warning member banks that tying arrangements are against the law. "NASD is concerned that the practice of tying commercial credit to investment banking is becoming increasingly widespread," it said.

According to the Association for Financial Professionals, tying is endemic. It surveyed 3,500 financial officers and found that 48 percent believed that "if they didn't award other business to short-term lenders, the amount of short-term credit would be reduced." And 39 percent said they didn't expect to get loans at all if they didn't award other business to lenders. "It's very much a real issue," says James Haddad, a member of the AFP's board of directors and vice president of finance at Cadence Design Systems Inc., a San Jose, Calif., software firm. "I've seen it throughout my career [in finance]. Every company sees it. Banks aren't bashful about letting you know they expect loans to bring in other business."

The treasurer of a Fortune 500 company who asked to remain anonymous agrees that tying has created headaches for corporate borrowers. (Most finance executives won't talk about the problem openly, for fear of damaging their banking relationships.) "It's nothing official--they don't ask you to sign anything," says the treasurer. "But it's understood that creditors are trusted to get their share of other banking business. That's just the way it is." The treasurer was forced to move the company's lock-box business to a new bank after the company secured a new line of credit with that bank, even though the finance executive preferred the existing one. The treasurer blames the practice on the low-interest- rate environment, explaining, "Banks don't want to lend money anymore."

The practice of tying could have grave consequences for the economic system, says Haddad. He says that plenty of large banks made big loans to companies based more on what fee-based business the loan could generate than on the creditworthiness of the borrower. That practice has already contributed to large losses in loans made to technology and telecom firms--losses that could affect the rates and terms of credit for companies at large. "Effectively, banks look at lending as a loss leader," says Haddad. But when they make bad loans to a company like WorldCom based on how much other business they can get, the backlash has an impact on all companies. "Everyone ends up paying higher fees and rates," he adds.

Rep. John Dingell (D- Mich.) is urging the Federal Reserve to crack down on tying. In a letter to Alan Greenspan, Dingell said he was "concerned about the implication of these practices on the health of the financial markets and on the availability of credit to U.S. corporations."

The prevalence of tying is largely a product of the consolidation of banks in the late 1990s, and of the repeal of the Glass-Steagall Act in 1999, which kept commercial banks out of the investment-banking business, says Dimitri Papadimitrious, president of the Levy Economics Institute at Bard College in New York. He doesn't think Glass-Steagall should be reinstated, but he does think regulators need to enforce existing laws, including those that prohibit tying. Says Papadimitrious: "I'm not so sanguine that regulators will do the due diligence on lenders until it reaches a crisis; then it's already too late."

Too Small to Keep

In this market you wouldn't expect companies to turn investors away, but that's exactly what some are doing. Why? To save money, of course, says Scott T. Gallagher, senior vice president at Georgeson Shareholder, a New York shareholder-communications firm. "Public companies are looking under every rock to eliminate hidden costs."

Odd-lot shareholder programs--in which companies offer shareholders with fewer than 100 shares a chance to either sell them at discounted fees or buy enough to hit 100--are making a comeback. Georgeson has conducted more than 700 of them.

Companies might be surprised by just how many shareholders fit the bill. On average, 55 percent of a company's investors hold fewer than 100 shares, but they represent less than 1 percent of shares voted, says Gallagher. It costs a public corporation more than $19 annually in servicing costs for every shareholder, regardless of how many shares he or she holds, according to a recent study by PricewaterhouseCoopers.

John Hancock Financial Services Inc. recently launched a voluntary odd-lot program. So far, the insurer says, it's "hitting its target" for eliminating odd-lot shareholders, but the company recently extended the deadline to participate by a month.

The average redemption rate is 30 percent to 40 percent, according to Gallagher, but investors don't always jump at the offer. International Absorbents Inc., a small-cap pet-care products company in Bellingham, Wash., recently launched an odd-lot program involving a share buyback. The company identified 90,000 shares held by odd-lotters, but at the deadline, only 3,198 shares had been redeemed. "Compared to what they bought the stock for, it wasn't worth it for a lot of them to do a trade," says Charles Tait, director of corporate communications. The odd-lot offer was $2.35 per share.

But the program, which ended on September 9, had a positive, if unexpected, outcome. "A lot of people decided to hold on to their shares," says Tait. "And some even bought more after I spoke with them."

Pension Plans: The Party's Over

Pension plan sponsors are living in the past. Some critics say that many companies have not updated their investment-return and interest-rate assumptions to reflect the current conditions of low interest rates and dismal stock-market performance. And while plenty of plans are now underfunded, the true picture could show underfundings at crisis levels.

"Plan sponsors have become increasingly aggressive. They're pushing the envelope on this stuff," says Stephen Church, president of Piscataqua Research Inc., a Portsmouth, N.H., consultancy. "Interest-rate assumptions are too high, as are investment-return assumptions."

Church says that plan sponsors are overstating interest rates--used to calculate a discounted present value of future liabilities--anywhere from 1 to 2 percent. The miscalculation has the effect of drastically underestimating what companies will owe future retirees in benefits.

Jeffrey Speicher, a spokesperson for Pension Benefit Guaranty Corp., which insures pension plans, says that pension assets have deteriorated. "Conditions are certainly very drastic right now," he says.

Indeed they are. A recent survey by benefits consultant Watson Wyatt Worldwide found that of 500 pension plans studied, the percent with enough assets to cover total pension liabilities had dropped from 83 percent in 2000 to about 33 percent this year.

That means that companies are on the hook to make up the difference. Even though General Motors, for example, announced this summer that it contributed $2.2 billion to its pension fund, the plan is still underfunded by $20 billion, according to an estimate by UBS Warburg. Church, however, says that using more-conservative assumptions, the actual amount could be even higher.

GM's plan assumes that investments will return roughly 10 percent annually. In 2001, however, the return on plan assets was a loss of more than 5.6 percent, and losses are expected to be higher this year. "Bad information leads to bad decisions," says Church. "Companies need to do more to make sure things are presented in fair fashion."

The Big Three's Big Ifs

Automakers' 2001 pension assumptions could hide shortfalls.

CompanyInterest rate

Expected return

GM7.2%10.0%
Ford7.2%9.5%
DaimlerChrysler7.4%10.1%

Source: Futuremetrics Inc.

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