Masters of the Obvious
September 8th, 2007I have been blogging for several months now about how money has been too cheap and how ill-advised acquisitions (by both private equity and strategic buyers) have been fueled by such cheap money (see here and here and here). Therefore, I was not surprised to see a recent article in the Wall Street Joural entitled “Deal Boom Fizzles as Cheap Credit Fades” summarizing the current state of the market for acquisitions.
The article is well written and pretty accurately captures what happened…
The global mergers-and-acquisition boom that began in 2003, the greatest deal frenzy in history, is winding down…within weeks, the market began to run out of steam. In August, there were about $222 billion worth of deals around the globe…the lowest monthly total since July 2005, and a far cry from the $695 billion figure struck in April and the $579 billion in July.
What fueled it [the M&A boom] was cheaply priced credit — bank loans and high-yield bonds were readily available. The biggest beneficiaries were private-equity funds, which took advantage of low interest rates and lax terms from lenders to make acquisitions more cheaply and with lower risks than corporations could. In 2000, leveraged buyouts accounted for only $14 of every $100 spent on deals in the U.S. This year, through July, they accounted for $37 of every $100. Earlier this year, investors were suggesting huge companies such as Home Depot Inc., then worth about $100 billion, as candidates for leveraged buyouts.
While I would encourage everyone to take a read of this interesting article, for those of you who have been following the markets (as I suspect many have), the content should strike you as patently obvious. Many have argued that credit was too cheap for too long – and not simply in the acquisition market – but across myriad credit markets, especially housing. This is nothing new.
Moreover, the article is retrospective. It simply recounts recent events. It does not provide any insight into what we can expect given such stylized facts.
So, what should we expect next?
Of course, we should expect deal flow to slow. We simply cannot continue the breakneck rate of the past few years. However, as I’ve also alluded to in previous posts, the next leg down should be increased bankruptcy activity as firms that were saddled with too much debt become unable to service that debt (not unlike many homeowners). Acquiring firms (whether private equity firms or strategic buyers) had been borrowing at between 5 and 7 times earnings (on average) over the last few years and burdening firms with that debt. Historically, such borrowing has taken place at around 4 times earnings. As a result of cheap and abundant credit, the default rate has been running around 1.4% over the past few years, an artificially low level, and well above their long-term average of 3%. Therefore, look for default rates to converge to, and in the near-term exceed, their long-run averages.
We’ve heard so much recently about how Jeremy Grantham has predicted that 50% of hedge funds will fail in the next few years (see here). I’d also venture that as a result of assembling portfolios of firms with excessive debt, some private equity firms won’t be far behind. And while 50% of private equity firms failing would clearly be a stretch, I would be shocked if it were only a handful.
Depending upon the severity of the slowdown of the U.S. economy, this scenario may end up slightly better, or potentially, a whole heck of a lot worse. I’m hoping for the former.
