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Since Dell went private in a $24 billion leveraged buyout (LBO), everyone’s talking about whether the days of massive deals with multiple private equity firms throwing down cash are coming back.LBOs — deals in which a private equity firm finances the takeover of company using relatively little equity and a whole lot more debt, were the thing to do for a while.
Then the financial crisis happened and, while stocks were cheap, it was impossible for PE firms to raise the necessary debt to buy companies.
Now everything has changed. There’s cash floating around and interest rates are low. On top of that, according to data from Private Equity International, buyout funds were the most popular private equity funds with institutional investors in 2012, raising 49% more money worldwide than in 2011 — $130.9 billion.
Still, there are serious reasons not to get excited for an LBO bonanza.
Back in November, Bank of America said that our current world of low yields and cheap stocks was ideal for leveraged buyout activity. Wall Street could start to see $5-$10 billion deals, but then the $20 billion deals would come, and we’d start to see some real leverage.
One could argue that we saw that this week when Silver Lake and Microsoft (with a $2 billion loan) teamed up to take Dell private in a $24 billion deal.
The thing is, as LBO pessimists might point out, that deal was only possible because CEO Michael Dell owned so much of the company — 16%.
That’s why Dell was able to get over the hurdle that Bank of America pointed out in its LBO report, finding enough initial equity to put into the deal.
From Bank of America:
The most constraining factor for deal size appears to be equity – not debt. During the pre-Lehman environment large LBO deals were possible as private equity firms pooled resources in so-called “club deals”. Subsequent litigation makes it less likely that enough firms are willing to pool enough resources anytime soon for such mega deals, in our view.
Bank of America hedges by saying that a PE firm could team up with a pension fund or other institutional investor, but again, the environment (cheap stocks, low yields, cash floating around) has to be right.
That leads us to another reason why pessimists argue that LBOs aren’t making a come back — the fact that stock prices are shooting up.
That’s where things get a little weird here. The Economist pointed out that since the crisis, something abnormal has started happening. Stocks are yielding more than corporate bonds and high yield junk bonds are falling in line with stocks.
This means right NOW could be a really sweet time for deals, but that may not last for long.
This suggests the possibility of an arbitrage: borrow money at a rate comparable to the junk bond yield and use it to buy public companies. That, of course, is a key ingredient in the private equity business model. As long as the target’s earnings grow over time and there are no problems with debt refinancing, this should generate a nice return. We may see more big leveraged buy-outs if this unusual spread persists.
Again, the question is how long this weird activity continues. We are seeing a great many changes these days, after all. Interest rates are rising, and who knows what that will do to corporate bond yields.
That means everyone needs to be careful out there, and that’s no kind of time for a bonanza.