Bond Market Tremors Hit Private Equity--and Stocks?

If you read the financial press regularly, you’ve heard of private equity deals. These are transactions where a company’s public shareholders are bought out, and the company “goes private” (meaning its stock ceases to trade publicly). Usually, an outfit specializing in these deals, called a private equity firm (they used to be called leveraged buyout firms), will borrow a pile of money and strike a deal with the management of the company to buy out the public shareholders. Other times, the private equity firm will buy a subsidiary of a public company, again using borrowed money. Once that’s accomplished, management of the acquired company and the private equity firm work to improve the company and then re-issue its stock to the public later at a profit.

One recent example of such a deal was Ford Motor Co. selling its car rental subsidiary, Hertz, in 2005 to a private equity group. The private owners of Hertz then made a public offering of Hertz stock about one year later, and by some accounts realized a profit on their investment exceeding 200%. That’s a lot of lunch money in a pretty short amount of time.

These private equity deals have been fueled by the availability of cheap credit. Interest rates have been low during the 2000s. It’s Econ 101 that when something is cheap, people will consume more of it. Credit is no different—look at how people rushed into the real estate market when lots of “affordable” loans were available. Unfortunately, many of those loans have proven to be a lot less affordable than they first appeared (as we discuss in http://blogger.uncleleosden.com/2007/05/true-price-of-affordable-loans.html). Access to easy credit in the real estate markets puffed up values and created bubbles in many regions that are now popping.

In a similar way, cheap credit fueled private equity deals. Low interest rate bonds, often issued with relatively few terms protecting bond holders (called "covenant lite" bonds), made a lot of the private equity deals possible.

The stock market is up about 18% from a year ago. One reason for this bubbliness is the rash of private equity deals that have taken place recently. Many stocks have been boosted by the expectation that they will be the subject of a private equity buyout. But the horizon is darkening, temperatures are dropping, and the wind is picking up. Interest rates have been rising in the U.S. and elsewhere around the world. Even though the Fed kept its target for the fed fund rate unchanged last week, market rates have risen because of the uncertainties in the mortgage markets (see our earlier blog about the subprime mortgage mess at http://blogger.uncleleosden.com/2007/06/subprime-mortgage-mess-on-wall-street.html). As interest rates rise, the attractiveness of private equity deals lessens. That’s because rising interest rates increase the costs of borrowing that finance these deals, and when costs rise, profits fall.

Last week, a private equity deal stumbled. It involved a grocery store company called U.S. Foodservice, which was a subsidiary of a Dutch company called Royal Ahold. Ahold sold U.S. Foodservice to a couple of private equity firms. They hoped to finance the deal with bonds. As a part of the transaction, a group of investment banks promised to lend the necessary money to finance the purchase first and then sell the bonds afterwards. This is called a “bridge loan.” If the bonds couldn’t be sold, the bridge loan would finance the deal longer term.

This time, the bonds couldn’t be sold. Investors wanted better terms than the bonds offered. Can you blame them? If a private equity outfit can make 200% plus in a year on Hertz, why would a bondholder want a relatively low return investment like a bond with relatively few protective provisions just to let some other private equity people make big bucks on U.S. Foodservice? With interest rates in a rising mode, being a lender to private equity all of a sudden doesn’t look as attractive as before.

A couple of other bond deals last week either had to be altered, or were called off, for much the same reasons. As the costs of private equity deals and other corporate restructurings rise, there will be fewer of them. And that means the impetus to stock prices that these deals provided will diminish. While the stock market has had a good run during the last 12 months, parties don’t last forever on Wall Street and it looks like the booze supply could be running low. The dollar has fallen against other currencies. That means potentially greater inflation in the U.S. It also makes investing in foreign stock markets seem more attractive. Also, the Federal Reserve Board remains concerned about inflation generally, which means it won’t lower interest rates any time soon. The housing market hasn’t found a bottom, and the mortgage markets continue to give Wall Street dyspepsia.

Not all of the picture is negative. The American consumer, as reliable as a Checker Cab, continues to chug and charge through rain, sleet, hail and snow. And unemployment levels remain remarkably low under the circumstances.

Corporate earnings reports will be coming out in the next few weeks. They, as always, will affect the direction of the market. But caution is in order. The availability—or not--of cheap credit shouldn’t be underestimated. Look what it did for the real estate markets--moving them up, and now down. As the bond market shivers, stock investors should think carefully about how much risk they want to carry.

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Stock Market Basics

For readers who are just starting out in the world of saving and investing, here are the basics of the U.S. stock and bond markets. (The financial markets of other nations can be quite different, so research them separately.) For more detail about the terminology, please look at our Glossary. There’s much more to learn if you want to become an active investor. But you can get an idea of the concepts here.

1. The corporation is an organization. It sells pieces of itself, called “stock,” in order to raise money to conduct business. (In other words, it takes money to make money, for corporations as well as people.) People who buy stock become owners (collectively with all the other stockholders) of the corporation.

2. Stock. When you buy a share of stock, you own a tiny portion of the corporation. The stock will increase in value if the corporation does well, and it will decrease in value if the corporation does poorly. Many people refer to stock as “shares” (as in shares of stock). If you want to invest in a particular stock, research it carefully.

3. Bonds. A bond is a way that corporations and governments borrow money. An investor lends them a fixed amount of money (e.g., $10,000), which is called the “principal.” They pay interest on the bond for a stated amount of time (e.g., 10 years), and then, if all goes well, they repay the principal (i.e., the money originally invested in the bond). Corporate bonds have “credit risk,” meaning the risk that the corporation might be unable to pay them. Government bonds are less likely to have this problem if they are issued by the governments of wealthy nations. But government bonds of less well-off nations can have significant credit risk. The riskier a bond, the higher the interest rate it will have. Be careful investing in bonds that offer a high return—the return reflects a higher risk that you won’t be repaid.

4. Mutual Funds. Mutual funds are a type of corporation used for investment purposes. Their business consists of investing in stocks and/or bonds. When you invest in a mutual fund, you are buying shares of the mutual fund. That gives you an interest in the fund’s holdings of stocks and/or bonds. The value of your mutual fund shares is based on the values of the fund’s holdings of stocks and/or bonds, and will increase or decrease as they increase or decrease in value. Most mutual fund shares are bought or sold at prices based on the values of their holdings of stocks and/or bonds at the close of the financial markets for the day. You usually buy or sell mutual fund shares by directly contacting the company that manages the fund.

Mutual funds can be index funds or actively managed funds. Index funds invest in a way that copies, or mimics, a financial market index, like the Standard & Poor’s 500 or the Nasdaq 100. Index funds have low costs and fees because they don’t have to pay professional money managers to strategize for them. Actively managed funds hire professional money managers to select stocks and/or bonds for them to invest in. These funds have higher costs and fees, because the professionals have to be paid to do the investment strategizing. Some actively managed funds are quite successful. But most do no better, or even worse, than index funds. An investor who is just starting out has relatively little, or nothing, to gain by investing in an actively managed mutual fund,

An exchange traded fund (ETF) is a special kind of mutual fund that can be bought or sold during the hours the stock market is open, at a price that normally reflects the most recent prices for its holdings of stocks and/or bonds. ETFs are bought or sold through stockbrokers.

5. The stock market and bond market are the principal financial markets for investors. They are open for normal trading from 9:30 a.m. to 4:00 p.m., East Coast Time. You can buy or sell stocks, bonds or exchange traded funds during these times. It is possible to buy or sell some U.S. stocks and bonds in other markets at other times. But the prices you get may be less favorable.

6. Stockbrokers are people and firms that serve as intermediaries in the process of buying and selling stocks. You can’t personally call or e-mail a stock market to buy or sell. You have to go through a stockbroker. (However, you can directly invest in or sell mutual funds--except ETFs--by contacting the company that manages the fund.) Stockbrokers charge commissions and/or other fees for their services.

7. Risks. You’ll probably have very little trouble getting information about the potential rewards offered by investments. You’ll probably have a harder time getting information about the risks (because people selling you investments tend not to emphasize their bad points). However, risk and reward walk hand-in-hand down Wall Street. The greater the potential reward, the greater the risk of loss. If you’re getting a glowing story about how great an investment is, but very little detail about the risk of loss, you will be at an informational disadvantage. You might be tempted to invest because you don’t know how bad the investment could be. Go back to cigarette ads from the early 1960’s. They’ll tell you that it’s enjoyable and sophisticated to smoke. But they’re rather short on information about heart disease, cancer and emphysema. Makes it tempting to light up—and that’s the idea. Make sure you know how an investment can go wrong before investing.

8. Investment Strategies. There are about eight and one-half zillion investment strategies. The large majority of them are (a) inconsequential (i.e., they won’t give you much of an advantage, or any, in the long term), (b) expensive (i.e., they require you to buy and sell investments often, which means large transaction costs that can significantly reduce your returns), (c) bunk (i.e., stupid, also referred to as dumb), or (d) fraudulent (i.e., a way to steal your money). Are there investment strategies that will prove superior in the future? Possibly, but you’ll have a hard time separating them from (a) through (d) above. Most professional money managers do not get returns higher than the stock markets as a whole and some do worse. That’s why investing for a return around stock market averages is a rational strategy. In general, most investors should stick to a simple strategy of investing on a diversified basis for the long term. See our recent blog on why the investor who does average is likely to do well. http://blogger.uncleleosden.com/2007/06/why-average-investor-does-well.html.

Also, take a look at the Investment Guidelines in Uncle Leo's Den at www.uncleleosden.com/Step11InvGuidelines.html.


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