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Jan 19, 2009

Debt issues

Monthly M&A roundup


If you need further evidence that debt is at the forefront of shareholder concerns, look no further than the scrapping of BHP Billiton’s $66 bn takeover of mining rival Rio Tinto.

A key factor in BHP’s decision to pull out of the all-share deal was Rio’s $42 bn net debt, a legacy from Rio’s purchase of Canadian aluminum firm Alcan in 2007. BHP’s own net debt level is much lower, standing at just over $6 bn.

Worsening conditions in the commodities market meant taking on such leverage had become too risky, comments Tom Gidley-Kitchin, an analyst at UK stockbroker Charles Stanley. ‘Everywhere you look you see all the risks going up, and going into that with a high level of debt is just the wrong thing to do,’ he says.

Marius Kloppers, BHP’s chief executive, pointed to this in a statement announcing the end of his pursuit of Rio. He said the ‘greater debt exposure of the combination plus the difficulty of divesting assets have increased the risks to shareholder value to an unacceptable level’.  

In today’s volatile market, a company’s financial health is best judged by funding costs, rather than any projected earnings or dividends. Indeed, a recent perception study by Thomson Reuters’ corporate advisory team put credit risk at the top of investors’ concerns.

So when BHP pulled the bid, the credit market immediately expressed the relief felt by investors. On that day, Reuters reported that the spread on five-year BHP credit default swaps tightened by 130 basis points to just over 300; by contrast, Rio’s spread remained unchanged at around 800.  

Along with Rio’s leverage, there is a second issue related to debt that affected the deal. To complete the merger, it is likely antitrust regulators in Europe would have forced BHP to sell some of its assets. But difficult-to-obtain credit means there would be few buyers so BHP would have to sell at depressed prices.

‘The scale of the divestments was going to be very big, and in a environment where there is no credit, your ability to sell at prices you would accept on a timetable that has been enforced on you would be very low,’ states Michael Rawlinson, an analyst at UK-based Liberum Capital.

Depressed prices may have helped scupper this deal, but they could lead to a rash of new ones over the coming months. Market commentators predict that BHP will take full advantage of its strong balance sheet to snap up smaller rivals on the cheap, while Rio could struggle under its heavy debt burden.

Details correct at time of going to press.