As the following graph shows, LBOs have surged in recent years:
(Announced value of all deals, including net debt; in constant 2005 US dollars; based on the date of the announcement and the residency of the target firm.)
Source: Bank of International Settlements 2007 Annual Report
Blogger Sudden Debt points out:
In 2007 thus far, global LBO’s are running at a rate 33% higher than 2006. So, it looks as if we may easily surpass $1 trillion in LBO activity this year – assuming the current rate is maintained. Total global market capitalization was $55 trillion as of May 2007; withdrawing almost 2% of market value in one year does wonders for stock prices.
However, there is an absurdity lurking here: private equity and LBO firms are taking dozens of listed companies private, but they are going public themselves. The whole process does not make any sense at all: we are being asked to pay a premium over and above what the LBO firms paid themselves in order to end up owning the same assets. It is little wonder that their IPO’s are not faring well, so far.
Add the recent widening of credit spreads which is raising borrowing costs (e.g. the CDX High Yield index has jumped from 275 bp to 455 bp in the past 45 days) and we may already have seen the peak of the LBO activity, which translated into high takeover premiums being placed on stock markets.
The underwriters of the $20 billion of Chrysler debt — JPMorgan, Citi, Goldman Sachs, Bear Stearns and Morgan Stanley — could not sell the $12 billion portion of the deal tied directly to the Chrysler auto business. The banks have agreed to take on $10 billion of the $12 billion portion of the loans, while Cerberus and DaimlerChrysler will lend Chrysler $2 billion to complete the financing.
In Europe, Deutsche Bank is the lead arranger of the loan deal to finance KKR’s buyout of U.K.-based drugstore chain Alliance Boots. According to a Bloomberg report, it and other banks involved were unable to sell $10 billion of loans out of a total $12 billion to finance the buyout.
The black eye comes as the banks and their Wall Street rivals have belatedly sought to rein in their exposure to risky debt. According to sources in the markets, banks have cut back funding to collateralized debt obligations that buy mortgage debt, and increased their collateral requirements for lending to hedge funds.
Issuance of CLOs soared to a record $57 billion in the first half of 2007. That has since slowed to a trickle. So far this month, just $1.9 billion of CLOs have been sold, according to Standard & Poor’s Leveraged Commentary & Data.
This comes at a critical time, because banks are in the process of selling more than $200 billion of loans to investors. CLOs have been big buyers of those loans, now many of them aren’t getting sold.
Last month, the near-collapse of two hedge funds managed by Bear Stearns rattled the corporate debt market. The funds made big bets on subprime mortgage-backed securities, but also held some CLOs, which were offered for sale as the hedge funds’ assets were being liquidated. It isn’t clear if the CLOs were actually sold, but the prospect of a fire sale spooked some investors and made them reassess their appetite for riskier corporate debt.
LBOs were profitable in recent years due to low borrowing costs and strong corporate profits. With interest rates on risky debt rising, borrowing has suddenly become much more expensive for private equity firms. But the nasty surprise will come when consumer spending continues to deteriorate leading to a decline in corporate profits. That is when the LBO bubble will turn into a bust.