Why Aren't There More LBOs?
With yields compressed to record low levels, thanks to Bernanke's repression, and a consensus expecting margin stability and a huge hockey-stick in earnings going forward, the question is why aren't there more LBOs? Earnings yields relative to high-yield financing is back up at levels seen during the LBO Boom of 2003-7 and Private Equity shops appear full of money on the sidelines, so why aren't there more LBOs? At its simplest level, an LBO is enabled by a relative mis-pricing between debt and equity ‘costs’ that a private equity firm can utilize to fund the deal (cheap credit relative to equity in the WACC). These factors appear defensible but the main fear we have is their sustainability.
Our strongest counter to a Public-to-Private boom is perhaps more simple though. The strength of markets in the last year is based on EPS growth (not top line growth) and multiple expansion as firms have crushed costs to maintain some semblance of margin growth (or stability) and Bernanke has flooded public markets with cash. The tendency towards LBOs being driven fundamentally by expectations of aggressive cost-cutting seems far lower in this environment. So whether its policy uncertainty or the reality that firms are massively Cap-Ex under-invested - which is cash flow intensive - PE firms know that acquisitions will need to bleed tons of Cap-Ex during their investment horizon - and no matter how attractive the 'deal', confidence in the future remains low.
As everyone awaits the 'done' deal at DELL, we suspect this will not open the floodgates of a new LBO Boom - as even money burning a hole in private equity shop pockets is unwilling just to throw it all away...
The benign macro environment of 2004-2007 allowed investors relatively easy access to credit and more efficient risk transfer of credit risk as securitization and derivatization virtuously reinforced one another. We neither have a benign macro environment or a securitization market to offset this highly levered debt - especially as we note the underperformance of HY credit markets over the past month. Cash on balance sheets is offset by the rise in cheap debt that has created it, and natural leverage has been on the rise recently too as cash burn has begun on a top-down basis.