Financial Market Turmoil Hurting Leveraged Buyouts
Changes in the credit environment brought on by this summer’s financial market turmoil will make it more difficult to make money through leveraged buyouts, according to Oxford Analytica.
Competition will increase and successful buyout funds are likely to focus on making real operational improvements in portfolio companies, rather than on quick transactions, Oxford says in a new analysis of the buyout market.
As a result of the crisis in the US subprime market, investors are now demanding higher risk premiums and tighter covenants on debt issues, Oxford says. “Currently, nearly 300 billion dollars of loans worldwide are assumed to be on banks’ balance sheets waiting for syndication. As long as these loans remain on the balance sheets, the banks are unlikely to finance larger new transactions.”
Assuming the global economy remains in reasonably good health and demand for buyout funds persists, Oxford says a number of changes are in store on the buyout front:
Longer holding periods and reduced returns. Lenders will reduce the amount of debt available for a transaction. With reduced debt levels, transaction prices are also expected to be lower. Funds owning portfolio companies will prefer to keep them for a longer period of time.
Reduced deal activity. Apart from other buyout funds, corporate and private sellers will also need some time to adjust their price expectations to the market. Transaction volumes, including secondary transactions, will decrease. Transactions of over 1 billion dollars are unlikely to get financed until banks have cleaned up their balance sheets.
Focus on operational improvements. Due to the slowed transaction market, buyout funds will focus their efforts on working with existing portfolio companies. In the past, a large part of funds’ returns was generated by favorable market conditions. Now, fund managers must demonstrate that they are able to generate premium returns in a normalized debt market.
Although the current credit crisis is likely to reduce returns of existing buyout funds, it should enable them to acquire companies at lower prices, Oxford says. Portfolio companies still benefit from a reasonably stable global economy and favorable pre-crisis debt agreements. Much will depend on how banks handle the backlog of loans on their balance sheets:
- Holding these loans to maturity would reduce future lending capacity and business opportunities.
- Renegotiated terms or selling at a discount would make the loans more attractive for investors but result in immediate losses. Currently, this seems the most likely alternative.
While eventual cuts in interest rates by central banks could lessen these losses, the crucial question is how long uncertainty will prevail in the credit market. If banks become unwilling to finance not only transactions but also necessary corporate investments, this could have significant negative effects on the broader economy.
The full report Buyout market is calming down is available for purchase.
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