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April 24, 2006 6:30 pm

Leveraged buyouts fail to appear on the radar screen

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Back in January, I pointed out the usefulness of using bond dealers’ leveraged buyout screens to pick stocks. Morgan Stanley’s credit researchers had come up with the original methodology for picking likely LBO candidates. Other dealers had used essentially the same model, so everyone arrived at more or less the same results. The back-tested results look pretty good: in 2004, the stocks popping up on LBO screens rose by 28.3 per cent, or 19.3 per cent above the S&P 500 index. In 2005, the LBO screened stocks would have made 13.3 per cent for you, or 10.3 per cent above the S&P 500 results.

I received a fair number of enquiries about the LBO screen methodology after that. Oddly, neither Morgan Stanley’s credit group nor its imitators had intended the screens to be a stock-picking tool. It just worked out that way.

And, ironically, the original purpose of the screens, to identify bond issuers that bond investors should avoid as potential downgrades, hasn’t worked at all this year, at least for large, investment-grade issuers. Those were supposed to be the companies most at risk from takeover by LBO funds but, in spite of the hundreds of billions sitting in LBO funds’ coffers and waiting to be spent, there have been no leveraged buyouts of investment-grade companies this year.

That wasn’t supposed to happen. The LBO funds’ managers use the same methodology as the bond managers, who were the original customers of the credit researchers’ screens (and the readers of this column who have started to use the screens as stock tip sheets) and they could presumably see the same opportunities.

Cheap investment-grade stocks don’t for the most part have the restrictive covenants in their bonds that prohibit the companies from taking on new debt. New debt is what you need for a leveraged buyout and, while in some cases it is still possible to do an LBO of a junk company, it is not as easy. That should have led to LBOs of investment-grade companies.

The cheap stock part is also necessary. We know, for example, there will be no LBO of Google. However, the managers of low-priced companies such as Louisiana Pacific and Eastman Chemical must be looking out of their leaking kayaks for the telltale wakes of investment bankers and their clients.

And yet, so far this year, nothing. While investing in value stocks such as those thrown up by the LBO screens has still worked well for the active private investor, the lack of LBO activity has had a real effect on the profit and loss statements of professional bond managers. The fear of LBOs pushed them out of taking what it turns out would have been profitable credit risk. Had I been a bond manager, I would have made the same mistake and underweighted the bonds issued by potential LBO targets. And, if you underperform the indices for more than a couple of quarters these days, you could find yourself setting up a home office and printing badly designed business cards describing yourself as a “consultant”.

David Goldman, a streetwise and mathematically sophisticated credit analyst who recently set up a research group at Cantor Fitzgerald, has done some interesting work on the no-LBO phenomenon. (You might assume all credit analysts are “mathematically sophisticated” but you would be wrong.)

As Mr Goldman wrote recently: “If we apply the capital structure analysis taught in every business school to particular cases, it is hard to find situations where intelligent investors would actually go through with an LBO.” Apart from cases such as the LBO of a Danish telecommunications provider, where the state-nurtured management did not realise the value of the embedded directory business, most managements are able to value their asset portfolio correctly. If some component business is undervalued, such as, say, a swathe of timberland or a government contractor that would do better as a standalone company, then management will, in most cases, sell the asset to a private equity group rather than wait for an LBO group to take over the entire company.

Mr Goldman’s analysis will come as news for those pension sponsors, insurance companies, bank trustees or wealthy investors who put up the money for LBO groups. But then, fiduciaries have to become accustomed to being taken for a ride by promoters. It is not as though the original analytics that drove the LBO business from the late 1970s to the early 1990s didn’t make sense. It’s just that everyone has read the plan by now. After being beaten up by predatory Wall Streeters and by offshored and internet-based competitors, most large corporations have learnt something about how to manage their business. Or, if they couldn’t manage it, they learnt how to sell it before it became a target.

It doesn’t help that real interest rates are rising, which means buyers of debt are becoming more reluctant to finance deals with hockey-stick projections of rising cash flows, particularly as we approach the end of an economic expansion. Credit investors are still taking risks but those risks are considered more attractive if they come as leveraged senior tranches of debt rather than high-yield bonds. That makes it harder for the LBO artists to snaffle up an arbitrage from putting up small amounts of equity while laying off more of risk on bond buyers.

This also illustrates an even more pervasive theme: there are too many second-rate people in the financial markets with more money than is good for them. The cookie-cutter LBO fund operators in particular think they have the right to the same compensation terms the LBO promoters earned from the mid-1970s. But back then the Kravises and Kohlbergs were shaking up and trimming a corporate America that was complacent. After the pain of the past few years, that opportunity no longer exists. The sector that needs trimming now is Wall Street, such as, say, the private equity and leveraged buyout promoters. Maybe a turnround expert, such as Steve Miller, the chief executive of Delphi, should turn his attention to them.

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