The Third Boom and Bust Cycle ‘03-’07
With the passage of the Sarbanes-Oxley Act of 2002 (SOX), in part to prevent financially unhealthy and cash poor companies from reaching an IPO as they had in the 1990s, the costs of reporting and governance that are associated with being a public firm grew significantly, helping make a go private transaction appealing to many public companies. Since privately held firms are not heavily regulated by governmental agencies like the Securities and Exchanges Commission or regulations such as SOX (also known as the, “Public company Accounting Reform and Investor Protection Act” and the “Corporate and Auditing Accountability and Responsibility Act”), this freedom can have major advantages. Without these strict regulations, private companies have greater operational flexibility and can focus more on long-term goals rather than quarterly earnings.
By the time that the economy had recovered from the burst of the dot-com bubble, interest rates dropped to historically low numbers. Private equity firms were raising funds that were larger than ever before. The historically low interest rates of the early 2000s ended when the Open Market Committee raised the Federal Funds Rate 17 times between 2004 and 2007. In order to remain competitive in lending to massive buyout firms, banks began to offer less restrictive terms on the debt-servicing capabilities of the PE firms and their targets due to their significant bargaining power. These covenant-lite loans provided increased loan repayment flexibility for the borrower. Key lender protections such as a requirement to report EBITA or loan to value ratios were not included in the loan agreement. Instead, banks hedged their increased risk in credit derivatives. In hindsight, covenant-lite loans have not seemed to perform worse than loans with covenants.
In October 2007, a consortium of investors took TXU (since renamed as Energy Future Holdings) private via leveraged buyout for $48 billion, making it the largest private equity buyout in history. In the Energy Future Holdings deal, which had required considerable lobbying efforts as nearly one-fifth of the United States’ energy production was at stake, the debt holders and private equity firms have since taken a loss and, although Energy Future Holdings generates a significant amount of cash, the company has considerable interest payments and a tower of debt due in 2014. But the economy had been weakened by the onset of the global credit crisis in the summer of 2007, making what was once cheap and plentiful debt harder to come by. Although partly due to the credit crisis, many of the large pre-credit peak buyouts left the target companies unable to support their debt and either defaulting or falling into financial distress.
Over the following few years, there was a large drop in the number of leveraged buyouts that were completed as well as some notable changes that were made in deal term practices which were aimed to increase the accountability of the buyout firms, including the weighted importance of reverse termination fees, exclusive remedy provisions and specific performance provisions, financing outs, and sponsor guarantees. Capital infusions, or cash injections from the buyout firms into the target company, grew rare and when used were done mostly to avoid covenant violations rather than reducing the debts that targets were buckling under.