I've been unable to post recently because I've been finishing a long thesis on LBO pricing from 1999-2009. I will post the paper on this blog in the next coming weeks. Until then, I thought I'd share my outlook for private equity activity going forward.
LBO activity will resume much quicker than one had thought a year ago. Public-to-private LBOs will certainly not die down to negligible levels as it was after the 1980s LBO boom. The 1980s LBO boom burst because of the fallout of the junk bond market, which was the main source of financing for LBO debt from 1985-1989. Junk bonds fed a takeover binge because they greatly increased the amount of credit available for LBOs. Junk bonds were a powerful financial innovation because they allowed insurance companies, mutual funds, and other institutional investors hold the debt of speculative grade companies.
The 2003-2007 public-to-private LBO boom was fed by a similar financial innovation. Structured credit allowed the same institutions that gorged themselves on LBO junk bonds in the 1980s to hold leveraged loans. However, the innovative power of structured credit was not as much syndication as ratings arbitrage. Financial technology made it possible to turn B rated debt into AAA, which there was much more demand for by financial institutions since AAA required less capital reserves. The chart below depicts LBO volume over CDO issuance (from Shivdasani and Wang, 2009, AFA Atlanta Meeting):
The structured credit market seems to be recovering faster than the junk bond market after the 1980s. Two weeks ago, Citigroup priced a $525mn CLO. A week later, Orix, Apollo, and Blackstone unveiled that they are arranging CLOs as well. Yesterday, BAML announced it is also arranging a $500mn CLO (called the Symphony CLO VII).
But credit availability is only one half of the story, LBO activity also depends on capital commitments from investors. LP activity is still subdued. Q1 2010 fundraising for private equity was at 2004 levels at $50mn (a quarter of the quarterly fundraising highs of 2007). But this misrepresents the amount of capital available to private equity. GPs are still sitting on massive amounts of capital raised during the highs of the buyout boom that has not been committed yet.
Even during the heights of the buyout boom, private equity firms held more capital as dry powder than investments. The buyout funds raised during 2007 have a term of 10-13 years. This capital has yet to find a home. Even if fundraising remains subdued, expect LBOs to once again become a weekly occurrence.
