The South Korea Decision:
Stop Leveraged Takeover Bubble
Before It Blows
Dec. 23, 2006 (EIRNS)—With the 2006 "debt-leveraged takeover" bubble apparently reaching $4 trillion or more in "market value,"—and threatening many nations with corporate debt blowouts—an effective way for governments to intervene and stop this destruction has been proposed. And in South Korea, it has informed a crucial November decision of the Supreme Court, which found many leveraged buyouts illegal under clearly defined conditions. The Republic of Korea Supreme Court decision indicates a precise model and political method for national legislatures—including in the United States, the epicenter of the buyout bubble madness—to intervene to reverse it before the corporate debt bubble explodes in "leveraged defaults" blowing out the credit markets.
On Dec. 14, economist and Democratic statesman Lyndon LaRouche made an aggressive proposal to stop the "bonfire of buyouts" which is loading target firms with new debt, looting these targets and their workforces, and driving them toward default. LaRouche proposed that any takeover that turns a viable firm into a junk-bond company is against the national interest.... Therefore, Congress should start to intervene to defend the national interest, and block the mergers, including any merger in which it can't be shown that the target companies will gain in capacity, productivity, and production from the merger. Congress has to draw that line, LaRouche said, and draw it now, in the face of the oncoming debt crash."
Rapidly Worsening Financial Cancer
Of the near-$4 trillion in buyouts—a record by 20% or more over the previous high six years ago—fully $500 billion or more of "market value" in takeovers has been done during the still-incomplete month of December.
Apart from the looting of many target firms already involved, the leveraged takeover boom now looks to many financial regulators like a repeat of the U.S.-centered housing/consumer debt bubble now bursting, but on a huge corporate scale. The Reserve Bank of Australia's just-retired chief Ian McFarlane, for example, is publicly warning that the whole Australian economy is "becoming leveraged," and could be producing a debt-jump like that of Australian household debt, which has leaped from under 50%, to 150% of disposable income in the past decade.
Over $1 trillion of the 2006 mergers and acquisitions will be in pure predatory takeovers by "buyout firms"—private equity and hedge fund locusts—as opposed to mergers between two companies in an economic sector. But even in the cases of mergers or buyouts of one operating company by another, the takeover costs are usually being paid in cash—not stock as in the 1999 merger boom—and the cash is coming from terrific amounts of new debt, borrowed from banks, hedge funds, etc. on the basis of "leverage," another name for the promise of looting and destruction of the companies and their workforces. "Lenders are increasingly willing to arrange aggressive financing packages for corporate clients," is how the Financial Times characterized the debt-default bonfire being stoked up.
New York financial community sources report that of the 30-40,000 corporate mergers and acquisitions worldwide this year, only perhaps 1,000 have been "leveraged" takeovers [premised on placing large amounts of new debt upon the target firm in the takeover], but these account for more than half the market value and most of the debt. About half of these involve hostile leveraged takeovers and/or attempts, which bids often involve very large amounts of new debt, and "valuing" of the target company at 20-40% above its current market value. These have become the primary driver of stocks for short-term investment strategies. M&As in general are now the main driver for the stock market, led by the large amounts of money to be made in playing the leveraged takeovers. Investment banks and lending banks are making very large risk fees, up to 2.5% of the whole takeover loan. For hedge funds, the takeovers are more profitable than their derivatives-based strategies, which are getting harder and harder to work.
The buyout firms' strategy in leveraged takeovers now, is to try to borrow as much as possible of the takeover price, and use the extracted cash flow of the target company, or the sale of its assets, for repayment.
Some very recent examples:
- Express Scripts' hostile takeover of Caremark Rx—a merger of two of the biggest "pharmacy benefit managers" of the HMO jungle—involves $14 billion in new debt, which is nine times the annual earnings of the combined target company. Caremark Rx debt may be downgraded to junk as a result.
- Qantas Airways takeover by the pirates of Macquarie Bank, Ltd. and Texas Pacific Group involves $9 billion in new debt, 15 times Qantas' earnings. "This deal is all about debt," warned one banker. Qantas' debt interest annually will rise from $158 million to $715 million; the Australian government warned Dec. 18 that Qantas' debt will be junk-rated and the government will not bail it out in future.
- Apollo Management Group's takeover of Realogy Corp.—which owns Century 21 and Coldwell Banker real estate companies—involves $7 billion in new borrowings from JP Morgan Chase and Credit Suisse. Realogy's debt was immediately downgraded to junk on Dec. 19, and the cost of insuring its debt against default leaped up, from 0.6% to 3% of the debt.
- USAir's attempted takeover of Delta will leave Delta with an immense $23 billion in debt, as opposed to the $10 billion debt it would have otherwise. This $13 billion in new debt is more than 25 times earnings when last Delta had any earnings, in 2003. According to Delta's reorganization bankruptcy filing Dec. 19, which opposes the takeover, it would lose 10,000 jobs, 180 aircraft, and a 10% shrinkage of the combined airline. And absurdly, $4-6 billion of the new debt is to be floated simply to pay off unsecured Delta debt which is now frozen in bankruptcy.
- The Freeport McMoRan Mining takeover of Phelps Dodge loads $15 billion in debt on the combination of two corporations which had no net debt; and produces a combined junk-rated company from two companies whose bonds were AA-rated.
- The Harrah's casino takeover by private equity firms Apollo Management and Texas Pacific involves $10.7 billion in new debt, doubling Harrah's total debt to five times its gross profits, or more than 30 times its annual earnings.
Korea's Model of the Needed Response
In November, the Republic of Korea Supreme Court made an extraordinary decision which which reversed one apparently "successful" leveraged takeover, declared it illegal, and reinstated criminal prosecution against the CEO of the takeover company involved. The decision was made in the "leveraged" takeover of an engineering firm of the Shinhan Bank group. This takeover, using debt borrowed against the assets of the company targetted for takeover, and the subsequent "restructuring" of the target firm to lower operating costs, had allegedly led to an increase in profits, and no personal diversion of funds or assets was involved.
The Supreme Court ruled the takeover a breach of fiduciary duty by the takeover firm, because of its and its CEO's prior intent to indebt the target company without compensation or benefit, and to subject the target company to economic burden, risk of default and impaired credit, and risk of contraction. No post-takeover actions or results could be considered as disproving this criminal intent, the Court ruled: The elements of the crime were complete, under the law, before the takeover took place, and had not been compensated by any payments or economic benefits to the target firm which could be shown prior to the takeover. Thus, the Court ruled, the takeover was illegal—and by implication, the "leveraged takeover" method is illegal as practiced by the private equity pirates.
The decision impacts other takeover battles, including prosecutions in South Korea, notably those by takeover specialist funds Lonestar and Texas Pacific Group/Newbridge.
Internationally, it provides a principled method for legislature, including the U.S. Congress, to stop the mad takeover wave—the method urgently proposed by LaRouche.