RSS FeedBy M. Isi Eromosele
Large number of LBO deals first began to occur in the United States in the mid-1980s. A deep market for publicly issued high-yield bonds developed at that time, which made it possible to obtain debt financing for large LBO deals.
European LBO activity gathered steam in the late 1990s and deal volumes are now comparable to the United States market.
Until mid-2008, the growth in LBO activity was largely driven by very favorable macroeconomic conditions, low global risk-free interest rates and abundant market liquidity. This generated a “search for yield” environment that led to low credit spreads, especially for debt with lower credit ratings.
This search for yield phenomenon and the structural changes in debt markets led a compression of credit spreads, particularly for lower rated debt instruments, including high yield bonds and leveraged loans.
Another contributor to low-debt financing costs was a structural demand for leveraged loans created by the development of securitization vehicles for such loans.
The resulting low corporate debt costs, in conjunction with high equity earnings made leveraged acquisitions attractive. This is because LBO deals take advantage of the yield gap between equity investments and debt financing.
In normal market conditions, capital cost tends to rise substantially after reaching an optimal debt ratio, reflecting a higher risk premium enforced by investors. Until mid-2008, capital costs for European corporates remained largely flat or even declined with rising debt ratios, suggesting that incentives to increase leverage existed.
In light of recent market turmoil, global LBO deal volumes have fallen by more than 25 percent. With the appetite for large deals falling considerably since mid-2008, LBO activity in the next few years will likely be driven by mid- to smaller deals.
The riskiness of LBO deals, measured in terms of the debt-to-earnings ratio, has risen in recent years, exhibiting a pattern similar to purchase price multiples. The compensation for risk, measured in terms of the spreads on institutional loan tranches per unit of leverage, has fallen in recent years.
This reinforces the view that growth in the LBO activity has benefited from low levels of risk aversion in the leveraged loan market. Since mid-2008, this trend has reversed and the risk compensation demanded by investors has risen sharply.
The low levels of investor risk aversion that prevailed until mid-2008 encouraged LBO deals to be structured with lower credit quality loans. However, given the varying levels o leveraged loan ratings coverage across geographical areas of the world over time, it is difficult to infer the trend in the overall credit quality of LBO loans.
LBOs versus Aggregate Trends In Firm Credit Risk
The increased risks in LBO transactions are occurring at a time when the aggregate level of corporate credit risk (as measured by ratings) has been trending upwards. The trend is also evident when one tries to control the asset size of the firm or the degree of leverage of the firm.
It is possible that the large increase in LBO debt issuance, in conjunction with a greater proportion of loans being rated, has contributed to the recent deterioration of aggregate firm credit risk.
The long-term downward trend in median issuer rating is a likely sign of structurally greater institutional investor appetite for lower credit quality firms.
Since mid-2008, the number of LBO deals has declined sharply as credit market conditions have deteriorated.
M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance
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