Monday, July 2, 2007

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 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 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.

Shopping News: for all you wine lovers, put away your charge cards. A couple of wrinkled bills wil do.

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