The Return of Leveraged Buy-Outs

 |  Includes: HOG, JNK, PLCM, SVU, TRW
by: optionMONSTER

By David Russell

The return of leverage has been the dominant theme in the stock market over the last year. It started when debt-heavy companies once left for dead began posting triple- and quadruple-digit returns.

That trend is now moving to the next level as deal makers look to use borrowed money to snap up undervalued companies in the form of leveraged buyouts. Takeover rumors are already swirling around companies such as Polycom (NASDAQ:PLCM), Supervalu (NYSE:SVU), and Harley Davidson (NYSE:HOG).

HOG Chart

A report by Bloomberg earlier in the month indicated that investors are sitting on about $500 billion of equity capital that needs to find a home. Continued improvement in the credit market also suggests that investors could see a continued wave of takeovers in coming months.

The Markit CDX.HY 5Y index, a measure of junk-bond borrowing costs, has now fallen below 500, down from 576 at the beginning of 2010. It's been steadily trending lower since peaking around 1,800 at the market's panic lows in March 2009.

"The combination of the credit market resurgence and tight spreads, attractive equity valuations and ample private equity 'dry powder' create the conditions for increasing the volumes of LBOs," Bank of America / Merrill Lynch's credit analysts wrote in a report to institutional bond investors last night. The bank reported on the trend in September, warning that buyouts threatened to harm credit ratings.

Earlier this year, data compiler Dealogic reported that LBO-related loan volume was up tenfold from a year earlier and that junk-bond sales were running at a record clip. That reflects strong liquidity, which will allow buyout firms to borrow the money needed to fund their purchases.

High-Yield Spreads ChartThe data is worth watching because healthy credit markets tend to beget healthy stock markets.

Most sentiment shifts appeared in the realm of bonds and loans before manifesting in equity prices: For instance, credit spreads started to widen more than a year before the Nasdaq peaked in 2000. Corporate bonds also started rallying in late 2002 before stocks rallied. Then of course we also have the crash of 2008 and the rebound early last year.

Another positive development is that the number of high-yield companies going bust has fallen for three straight months. The default rate, now at 11.6 percent, is an important indicator because it tends to move in longer-term cycles along with the broader economy. Once it starts getting better, it tends to gain momentum and continue for more than a year.

Earlier this month we also reported that Blackstone was unloading shares in TRW (NYSE:TRW) after the auto-parts maker had returned to the level where it went public in 2004. This will likely become more common as the equity market gains. It could also free up more LBO capital and increase the ease of doing deals. As with many things in finance, increased liquidity tends to produce greater confidence and thus higher multiples.

(Chart courtesy of tradeMONSTER)