Private strife

With private equity breaking into Scandinavia, bondholders must be aware of the risks, says Troels Askerud

The Scandinavian market is seeing a large number of takeovers, with many more likely to follow. International private equity investors are beginning to discover the potential return in the region.

Scandinavian countries, not least Sweden, have some of Europe’s highest rates of gross domestic product going into private equity. ISS, Skype Technologies, Mölnlycke Health Care and, most recently, Danish telecom provider TDC are just some examples of both regional and international investment houses’ expanded M&A activity in the region. And while the first wave of buyout investments from private equity funds focused on medium-sized industrial companies, even the very largest companies are now considered potential investment targets.

The arrival of private equity houses to the Scandinavian financial market has not been uneventful or unproblematic. One case especially – the leveraged buyout (LBO) of Danish facility services provider ISS in 2005 – received huge attention in the media, creating a widespread hostility, or at least scepticism, towards the new players and their motives.

ISS: bondholders v equity owners

In the spring of 2005, private equity houses EQT and Goldman Sachs placed a bid of $2.97bn (£1.7bn) on the Danish service company ISS. ISS’s management made recommendations to the stockholders to accept the bid, unaware of the new owners’ plans for how to finance the buyout.

After the sale and unlisting of the company from the Copenhagen Stock Exchange in May 2005, EQT and Goldman Sachs revealed the plan of financing a large part of the takeover by tripling ISS’s debt to more than DKr20bn (£1.87bn). The plans for the LBO caused an immediate 20 per cent drop in the bond price of the two existing bond series, leaving the bondholders with a sudden loss of more than DKr2bn (£187m). The bondholders threatened the equity owners with lawsuits, claiming that the plans were a breach of the company’s legal obligations towards the existing bondholders. EQT and Goldman Sachs eventually changed their financing plans, although arguing that the change of plans was not due to the threat of lawsuits. A second threat of lawsuits from the angry bondholders was also avoided after discussions and mutual agreements between the equity owners’ and the bondholders’ legal representatives.

Bondholders are not victims

There is a widespread perception that LBOs from private equity investors are unfair towards the company’s existing bondholders, as in many cases they lead to a price drop and a downgrading of the existing bonds. However, in some instances this is misplaced. Bondholders are opportunistic when they act offended or claim to be a victim of the private equity investors’ crusade.

The price of any bond is based on, and influenced by, the balance between perceived yield and risk. When you buy a bond with a ‘high’ interest rate, you must also anticipate and accept a higher degree of risk. A low, and therefore favourable, bond price indicates that the nominal interest rate should have been higher. To put it simply, as an investor you have to make up your mind how ‘greedy’ you want to be. If you are more risk averse and hence accept a lower yield, you choose a low interest bond or effect a credit insurance. If you are more greedy, you skip the insurance and run the risk yourself. But then you must also accept that the credit rating, and subsequently the bond price, may drop at some point, for example if an LBO should occur.

What many people do not realise is that investment banks, private equity houses and all other players in the financial market are in the business of buying and selling risk. The banks buy risk and the price of that risk is reflected in the interest rate the issuer offers on that proper bond.

The dramatic events following the buyout of ISS have had positive effects for the financial market in Scandinavia. The large attention the case received in the media has given rise to an increased awareness in the market on the terms with which the bonds are issued, both from investors’ and issuers’ sides. In the recent and equally dramatic buyout of Danish telecom provider TDC, the new group of equity owners have voluntarily chosen to offer to redeem from the bondholders almost all outstanding TDC bond series at their nominal value in order to keep a good relationship. Other companies have offered far-reaching change-of-control clauses when issuing bonds.

Investors have also become more aware of their investment terms and risks and have increasingly become aware that there are ways to protect themselves against LBOs. One opportunity is to invest in credit default swaps as a credit insurance.

It is likely that there will be an increased interest in credit default swaps among Scandinavian arrangers, issuers and investors. Very few Danish institutions currently offer swaps on regional risks, so an investor may have to turn to the London Stock Exchange. But with the increasing focus on how to protect investment, that pattern may change.