The Dell-EMC deal might force the companies to do a very large high-yield debt offering at a time when the market is not ready for it.
Dell may be looking to do the right deal at the wrong time.
The computer maker and private equity firm Silver Lake Partners are reportedly in advanced talks to buy EMC EMC in a leveraged buyout. The acquisition of the computer storage company could be the largest technology deal in history, and it would push Dell further away from its traditional computer business and more into servicing large corporate customers. But the move would be very costly. Dell is reportedly looking to borrow as much as $40 billion to do the deal. And that could be a problem.
The financial turmoil of the past month has brought the high yield debt market to a screeching halt. Investors have been particularly worried about debt deals used to fund acquisitions. A number of deals have been called off or shifted to the loan market. Late last month, chemical company Altice had to cut back a bond offering and increase the interest rate to 11% on a portion of a multi-billion dollar deal.
Just $12 billion in high yield bonds were issued last week, down from $34 billion during the same week a year ago, according to S&P Leverage Commentary and Data. Total issuance of leveraged loans and high yield bonds is down by nearly $140 billion this year compared to 2014, to about $575 billion.
“Look at the size of the [Dell] deal,” said Keith Bachman, who is the head of U.S. high yield bonds at Aberdeen Asset Management. “One has to question the high yield market’s ability to swallow something like that right now.”
Dell would likely have to pay handsomely to issue so much debt, even if it ends up being able to do so. The average BB rated bond, which is what Dell’s current debt is rated, is trading at a yield of 5.8%. Some said in order to get the EMC deal done, Dell might have to pay an interest rate as high as 7%. That’s significantly higher than the 4.63% interest it got when it issued bonds to fund its own buyout a few years ago.
Another obstacle could be the leverage ratio. These days, the average leverage ratio, which compares debt to a company’s cash flow, on LBO deals has been about 6.4. When Dell took itself private two years ago, it had relatively little debt and a leverage ratio of just 4.8. But a Dell-EMC deal would be higher than that.
It’s hard to say how much more because Dell stopped issuing financial statements after it went private. But in the last year it was public, the company had roughly $2.5 billion in cash flow. EMC had just over $4 billion in cash flow last year. So, if Dell is looking to borrow $40 billion to do the deal, and you add the $12 billion it had after its own LBO, you get $52 billion in total debt. That would give a combined Dell-EMC a leverage ratio of roughly 8. It’s probably a bit lower than that, given that Dell’s earnings have likely increased over the past two years. But it’s still high. And EMC will also have to deal with its large stake in storage software company VMware, which activist investor Elliott Management has wanted EMC to spin off. High-yield bond investors might be looking for the same.
That doesn’t mean the debt market will leave Dell high and dry. Given who is involved in the deal, the banks will likely make it happen. And bankers are already talking about cutting up the deal into some high yield and some investment grade debt. That might lower the amount of debt entering the high yield market.
What’s more, it could be a while before the deal gets done. And the high yield bond market is already showing signs of improvement. After losing nearly 3% in September, the high yield market has been coming back. What’s more, Dell is not in the energy business. That’s a very good thing. Energy companies have made up a good portion of debt issued in the high yield market over the past few years. That’s left a lot of junk bond fund managers with plenty of exposure to the energy sector at a time when oil prices have crashed and defaults, particularly among fracking companies, are rising.
That could be very good news for Dell. With junk bond managers looking to diversify their portfolios, some may be in the market for a large tech deal. “There will be interest in something like Dell,” says Martin Fridson, a high yield strategist at Lehmann Livian Fridson.