Why doesn’t a PE firm do well in Chemical business?

Chemical companies were always considered a very good credit risk, given their cash flows and fixed assets as well as diversification through their cross-border activities. Except for liability lawsuits, very few large chemical companies ever went bankrupt. Even highly leveraged large transactions were successful — from Union Carbide in the 1980s to the Gordon Cain transactions and the more recent acquisitions of Nalco, Celanese (lucky deals) and LyondellBasell, Hexion/Huntsman (not so lucky deals).

The fact is typical private equity firms (even Bulge Bracket firms, let alone middle-market buy-out firms) do not do well with chemical company investment due to their: i) short-term focus [“catch me if you can” mentality] ii) lack of understanding of complex chemical business where financial engineering may not be enough iii) timing the economic cycle often difficult and IPO may not be an easy exit strategy.

I believe, one of the key criteria to be successful in chemical industry is to maintain TRUST and long-term relationship. Traditional private equity often only focus on low price of a chemical business (say 4 to 6x EBITDA range) instead of the long-term value of a business. At the same time, the level of distrust among traditional Wall-Street players are more than ever, causing problem to raise reasonable debt. While many other sector players are paralyzed and remain static, the chemical industry folks are busy in debt raising or financing due to good fundamental and here are a few examples.

Ashland Chemicals (ASH) announced a few weeks ago to issue $600 million of unsecured senior notes due 2017. ASH will use net proceeds from the offering along with free cash flow generated (which we estimate to be $383 million in 2009) to retire the $750 million 9% bridge loan facility that is set to mature and roll over to an exchange note (at a likely even higher interest rate) in November of this year. By taking out the $750 million bridge loan before maturity, ASH can prevent it from potentially being rolled over to an exchange note that we believe would likely bear interest in the 12-14% range. While the ultimate impact of the pending debt offering on ASH’s interest expense is yet to be decided, we believe that it 1) reduces ASH’s financial risk, 2) eliminates the near-term maturities that were weighing on the stock, and 3) could potentially even result in a lower interest expense going forward.

Nalco Chemical Company (NLC), has issue $500 million aggregate principal amount of 8 1/4% senior unsecured notes due 2017 (the "Notes"). The notes will be issued at 97.863% of the principal amount to yield 8 5/8%. Nalco Company intends to use the net proceeds from the offering, along with proceeds from new credit facilities, comprised of a seven-year $750 million term loan credit facility and five-year $250 million revolving credit facility, to repay outstanding debt.

DOW Chemical (Dow) reduced its financial leverage, shrunk its near-term debt obligations and eliminated its extremely expensive perpetual preferred notes with the issuance of $2.25 billion of equity as well as $6 billion of longer-term debt.

Rockwood Specialty (ROC) has successfully completed an amendment to its credit agreement, allowing the company additional financial flexibility through its covenants, and extended maturities of its Term Loan E and Term Loan G, however all this did come at a price. Rockwood has amended its leverage covenant definition and level from Total Debt/ EBITDA of 4.25x to Senior Secured Debt / EBITDA of 4.40x, stepping down to 4.00x by the end of 2010. I believe, the credit agreement was little pricy, $8.7mm in one-time upfront fees (keep in mind that ROC was owned by KKR and it was highly levered during IPO…. Very similar to Nalco). This adjustment leaves the company significant room under the covenant--well beyond what is needed in this economic/earnings environment and gives them room for acquisitions if the opportunities arise. 2009 EBITDA estimate (excluding FX gains and losses) is $530.1mm. Next, Rockwood will extend maturities of $1.22 billion of Term Loan tranches E and G to May 15, 2014 from July 30, 2012.