Don't panic, diversify

Leveraged buy-outs

Memani: portfolio diversification a better defence than drawing up lists of likely LBO targets

For hedge funds and prop desks armed with the ability to go short using cash bonds or credit derivatives the prospect of being able to play the same game as their equity long/short and merger arbitrage cousins for the first time was very appealing, as Euromoney reported last month.

Traditional bond investors tend to have the opposite reaction. With good reason: if they hold debt in companies that become targets their portfolios could take a hit. For one thing, companies that are subjects of LBOs often get downgraded. What's more, those holding unsecured long-dated debt before an LBO get put in an even worse position after more bridge, mezzanine, secured and unsecured debt are added on to make the transaction work. Such investors, wrote CreditSights analysts Louise Purtle and Glenn Reynolds in a report on LBOs last month, “just end up coming along for the ride in a structurally subordinated position while operating as de facto equity risk for fixed-income returns”.

That's not an appealing outcome for most traditional investors, so it's no surprise that the prospect of a resurgence in LBOs has prompted them to start digging for lists of candidates. It's a throwback, point out Purtle and Reynolds, to the heady LBO days of the late 1980s and the late 1990s.

CSFB credit strategist Krishna Memani pointed out the best and most obvious defence against any resurgence of LBOs in a report in August: diversification is the best way for regular portfolio managers to avoid any undue hits should one of their credits be involved. “Unfortunately the more popular approach has been to identify a set of issuers to avoid because they are ‘probable' LBO candidates.”

In their report Purtle and Reynolds also try to put a dampener on the fear-induced list-making tendencies of long-only bond holders. But they do so by crunching the numbers to come up with their own list to show just how the next crop of LBOs are unlikely to have an impact on portfolios.

They identify the kinds of companies that are more likely to be favoured candidates for LBO funds to go after. There are, they say, three main characteristics that are likely to dominate. These are: “an increased focus on releasing entrepreneurial value rather than asset value and a corresponding rise of activity in younger companies in expanding industries such as technology; a shift towards more offshore companies, which tend to operate at lower leverage levels; and a greater concentration of smaller companies or divisions of larger corporations as opposed to medium-to-large public corporations”.

Number crunching

They then crunch the numbers, which they admit “were defined at somewhat arbitrary levels but were selected with an eye to broad practice in the LBO market”. Their four criteria are: EV/ebitda ratio of less than five; current market capitalization of less than $3 billion; current market leverage less than the average level for the relevant industry; and current P/E ratio less than the average level for the relevant industry.

Purtle and Reynolds caution that the results are just an indication and don't take into account a variety of other factors. However, they show that bond investors have a lot less to worry about than they might think. Of the companies in the S&P 1500 Composite index, only 44 came out as potential targets. And of those only one, Healthnet, is in the Merrill Lynch investment grade index and only five others in the Merrill Lynch high-grade index.

If the market cap ceiling is raised to $10 billion only another seven names make the final list. Widening it out to the Russell 3000 companies, 225 companies make the final list.

It might not stop the short-term effects of some speculation by hedge funds, but it might give traditional investors some comfort that they're not about to lose their skins to another horde of barbarians storming the gates.