LBOs: Largely Built on Optimism
It’s usually European politicians that get it in the neck for being blind to Europe’s debt-shaped problem. But is the LBO market equally guilty?
Manchester United, Bayern Munich, Barcelona. As a footballer, Mark Hughes strutted across Europe gaining fame and accolades. As a manager, he wanted to rule the world, leaving Fulham in 2011 claiming that Mohammed Al Fayed’s ambitions for the club did not match his.
So it was that he found himself at the mighty Queens Park Rangers FC, returning from the wilderness to sign champions league winners, Brazilian internationals and Real Madrid graduates. This week he was fired, after precisely zero victories from 12 league games.
To the end he maintained that he was the best man for the job, that no one prepared his players better than he did and that the team was playing well. His words fell on mystified ears, but it was an admirably resilient front.
If you hadn't realised by now, QPR holds a special place in the heart of this writer. But if any asset class lends itself to the hubris of professional football stardom, it's leveraged finance. It's racy, glamorous, dramatic and played for high stakes. And like Hughes, it's been kidding itself into thinking that its past glories count for something.
The world is stuck in a low-yielding, low-growth rut, but the private equity industry refuses to countenance cutting its return requirements. Hurdle rates are frequently in the region of 20%, but there is simply no logic in returns on LBO investments being out of kilter with the rest of the world.
Bankers are also cutting increasingly frustrated figures. Dividend recaps, which had been out of favour for more than four years, are getting done without sweat. But the unrealistic expectations of company vendors have left levfin bankers starved of new business. The number of promising attacking moves that have not hit the target, in the form of failed auctions, has left them weary.
The rally mirage
For the last two years, the apparent “rallies” in the leveraged loan market have been little more than a facade of repayments into scavenging CLOs desperate to keep themselves invested — and thus in existence.
It is a widely-held view among bankers that European politicians have spent two years dilly-dallying and achieving little, while nothing much fundamental has changed.
But the mood in the leveraged loan market would have you believe that that we’ve been through an entire boom-bust-boom cycle in less than 24 months — a half-year-long dead market (which came to an end at the end of 2011), sandwiched between aggressive periods where sponsors have wielded all the power.
These changing dynamics have simply been a function of the amount of paper available in the market, and the amount of money that high yield bond refinancings or trade buy-outs have directed into the pockets of CLOs.
They are certainly not to do with any real changes in the macroeconomic outlook that could lead to a resurgence for leveraged buyouts. Highly-leveraged companies usually have to grow just to pay down their debt, let alone return equity to their owners. And while there are always some companies that can beat the wider world, the number of companies on which buyers will take an aggressive bet is going to be limited.
So perhaps the only option is to get used to this one-deal-a-month nonsense that’s terrible for your earnings but great for Starbucks’ UK revenues (but not profits, mind) as you fill up on coffee to keep you awake at your desk.
There is another way
It doesn't have to be like this, of course. The fact that LBO sponsors have been living in their own bubble in recent years is no surprise, given the cheap CLO funding that was shovelled their way some five years back, and is still supporting today's aggressive deals. But that will not be around for much longer — by the end of 2013, it will be minimal.
Private equity should lower its return requirements and realise that a return in the 15% range is still pretty attractive at a time when even high yield yields are, well, not high.
Importantly, this kind of adjustment will allow the industry to accept a higher cost of debt, and that ought to attract a more sustainable investor base into the leveraged loan market.
Thinking a little less lucratively and a little more pragmatically could see the number of deals pick up again — and that should work in everyone’s favour. Adjust your expectations, levfin, and you may give yourself a better chance.