LBOs to survive credit shortfall: Barwon

The leveraged buyout (LBO) market can still serve up favourable returns, despite diminishing multiples and the credit troubles beginning to undermine the sector, research from Barwon Investment Partners advises.

Although a confluence of factors – the recent widening of credit spreads, rising costs of leverage, higher asset prices and weaker operating conditions – will tame LBO returns by as much as 5 per cent each year across the board, there are still opportunities to generate returns, particularly through improving the operational efficiency of acquired companies, the research states. Although the relative free-flow of debt has seized up somewhat, it is still available, and interest costs have remained low in a historical context, despite enlarged credit spreads. Smaller Australian deals should not be impacted to the extent that larger, international deals that have relied on hedge funds and collateralised debt obligations for debt will be. While Barwon declares that multiple expansion is “over”, this doesn’t consign deals made in recent weeks to the same gloomy fate: Barwon modelling shows that a company bought and sold at the same 6.5 x EBITDA multiple can still satisfy investors, serving them an annual 20.8 per cent internal rate of return (IRR). This compares with the heady earnings of recent years, where assets were bought at 6.5 x EBITDA and sold at 8.5 x EBITDA, generating an annual 27.1 per cent IRR. “As long as a company’s free cash flow is sufficient to pay down debt, significant value for investors can be created. This is the power of the LBO model,” Barwon states. Backing up claims that LBO returns will moderate, the research explains that since ‘easier’ LBO gains made from leverage and multiple expansion are now expected to subside, future returns would be sourced from managers improving the operational capacity of companies they have bought. Barwon notes the speculation that Australia’s major banks are holding more than $200 billion in leveraged loans, which could take up to a year to be repaid, amounting to a log-jam of loans and a serious case of “market indigestion”. As a consequence, the number of mega-deals, like those witnessed in recent years, will diminish until it has calmed. The equity component of leveraged loans decreased from 41 per cent to 35 per cent between 2000 and 2006. Barwon expects these levels to scale to 40 per cent. Contagion from America’s subprime mortgage morass had pushed out credit spreads to 3.5 per cent plus LIBOR, from 2.3 per cent, the research stated.