May

29

 It should be noted that investment grade bond domestic bond issuance set a monthly record as of Friday, with borrowers selling $105.92 billion in securities (and the month isn't over, with three full days remaining.)

Among the commentary supporting the debt binge, equity strength is highlighted, as well as the perception that despite the aggressive pace of LBO/PE deals. The thinking is that it will be a quite some time until a high-profile deal melts down. Moody's agrees, apparently, with a report issued last week forecasting a decline in default frequency to a record low.

And the proceeds? S&P 500 components have spent more than $440 billion on share repurchases over the past 12 months, according to J. P. Morgan.

Alston Mabry writes:

Having spent a while recently as a spectator at a PE buyout, from the acquirer's point of view, I can offer this observation from the cheap seats. The PE craze appears to be fueled, just like the hedge fund industry, by cheap leverage. The buyout firms are using leverage at 5% to buy cash flow of 10% and pocketing the difference. On a $5B deal, that's $250M/year. And if a few years later somebody comes along and offers you a price you can't refuse, like Riverdeep did for Houghton, then so much the better.

So where's the weak point? Or is it a free lunch? If there were to be a downturn that pushed too many of those cash streams negative, but still the interest payments on the leverage keep coming due, then could some buyout groups get hurt?

Stefan Jovanovich comments:

I doubt that where we sit qualifies as "seats". Even calling the location a knothole in the fence is probably an exaggeration for our odd-lot venue.

Over the last 12 months the return on common stock investments net of commissions before taxes was 19.65%. The pre-tax, post-expense return on our private investments during the same period was twice that - 38.52%. Alas, no one is eager to buy that private cash flow with or without leverage because the world of finance capital for small private businesses here in California no longer exists.

The roll-up boys are long gone and so is small business lending unless you include your Capital One credit card in that definition. The returns on small business equity here in the Golden State will continue to be outsized because there is no way for going concern values to be monetized. No one in their right mind wants to acquire legal employees unless they have already amortized that risk with a full-blown HR department.

If our situation is at all typical, then the flow of capital from small business owners into securities may have a great deal longer to run. We make a great deal of money from our private business, but we know that every new investment in it is truly sunk. We can only get a return from operations, not from selling.

Philip J. McDonnell writes:

In a way the return on private equity is higher than the publicly available equity. With the advent of Sarbanes-Oxley the costs to comply went up for public companies. It simply added costs to their operations with no compensating income gain for the companies or the investors. In addition to that there always was some kind of added cost borne by public companies. As usual the regulatory costs only ratchet upward never down.

With the example of a public company with a 10% return (PE=10) which is purchased for money that was borrowed at 5% giving a net 5% after interest cost return, the real situation may be better. In fact given the regulatory savings the newly private company may be able to yield 11% thus boosting the net return to 6% which is a 20% better ROI.

The benefits do not end there. There are no margin calls in private equity. Contrast that situation with a typical highly leveraged hedge fund. The hedge fund can borrow too. But if it is trading marketable securities there will be margin calls. Typically the portfolio will be marked to market daily and immediate liquidations will ensue if the value falls below minimum margin requirements.

For a private equity firm there is no daily quoted valuation. There is only the book value shown which is typically a high and inflated number set at the time of the buyout. The lender is actually looking to the cash flow more than any vague concept of market or portfolio value. Lenders want performing loans. To them performing means the borrower is repaying as agreed. It is capitalism as it was designed to work. When the government finds ways to regulate and to restrict credit the markets find ways around it. Ultimately the markets will rule.


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  1. Gary Rogan on May 30, 2007 9:12 pm

    Sooner or later the PE craze will end in a disaster. First the 5% delta will come down to 1%, then something will interrupt the cash flows, and a large percentage of the loans will become non-performing. Huge banks will fail, the Fed will have emergency meetings and all that stuff. Such is the fate of all bubbles, but since no one knows the timeframe, there isn’t much to do but to watch it play out.

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