More sober times ahead

These past few years have seen an explosion of leveraged buyouts, or LBOs. Marauding companies and private equity firms have borrowed mountains of money to fund corporate takeovers. Indian companies have been active participants in the LBOs as well, with a blaze of well-known deals that seem exhilarating and risky at the same time.

The entire LBO party has been fuelled by cheap money because interest rates have been very low in recent years thanks to central banks across the world. In other words, LBOs have been an arbitrage between the credit markets and the market for corporate assets. You borrow from one to buy in another.

The ground is now shifting below the feet of the partygoers, as borrowing costs in the credit markets have started inching up. The contagion that started off in US subprime mortgages, or housing loans given to borrowers with poor credit histories, is spreading. US Fed chairman Ben Bernanke told the US Senate on 20 July that losses in this business could reach $100 billion, which is far more than anybody but the most rabid pessimists expected when the trouble started. It is clear that the two Bear Stearns hedge funds that invested in subprime mortgages are now worthless—all their assets have been wiped out.

Nobody knows for sure what other demons are in wait. Perhaps this is the end of the contagion rather than its early stage, but Bernanke’s testimony and the wiping out of the two hedge funds have got the credit markets worried. They are more careful about taking risks. Credit spreads, a measure of investor nervousness, have widened. Once again, they are nowhere as wide as they were in 2003. But the direction is clear—credit spreads have started widening. They are up 27% since 1 June, according to Bespoke Investment Group. The interest rates of risky debt have bottomed out and started to climb.

How does this affect LBOs? Since there is a lot of uncertainty in these buyout deals, acquirers usually find it difficult to raise long-term money from banks till the deal is done. Mopping up money by selling bonds is almost impossible, once again because the structure of the deal is unclear till the very end. So many LBOs, including the ones done by Indian companies, have to initially depend on short-term loans from banks—or bridge loans. These loans are paid off the moment long-term debt is raised from banks and the bond markets.

Hence there is often a gap of a few months between the closure of an LBO deal and raising long-term money from the markets. The big question is what happens if interest rates shoot up in the interim period. Say a company has gone into an LBO deal assuming that it will pay 8% on its debt. Then interest rates on high-yield bonds jump to 10%. The entire economics of the LBO can spin out of control.

“Selling high-yielding debt to investors has previously been among the easiest jobs in the capital markets, but credit bankers are likely to have to work much harder to earn their fees in the second half of the year. A succession of leveraged loan and high-yield bond financings have been postponed or restructured as investors have grown wary of riskier securities," writes Duncan Kerr in Financial News, an online journal on the securities market. He says that Tata-Corus is one of the companies that “is expected to take large, high-yield loan and bond issues to the market in the coming weeks."

All this suggests that the troubles that started in the US subprime mortgage market have rippled out, and will perhaps be washed onto Indian shores. This column has written about the risks to Indian companies from LBOs earlier. Not every attempt to borrow lots of money to buy another company will end in a mess. There will always be successful LBOs, where the extra cash flow from the merger pays for the extra debt.

But the LBO game was a bit too easy over the past couple of years, thanks to the low price that investors demanded from those who took large risks. Companies have been goaded along by their ambitions and the encouragement they have got from bankers who collect large fees during such deals. Despite the warnings sent out by credit-rating agencies, agencies such as IMF, as well as the discomfort among investors, the LBO bandwagon has rolled on without a care in the world.

It is very likely that the current skittishness in the global credit and high-yield bond markets could give the bandwagon a welcome jolt. Private equity companies and LBO acquirers are expected to raise billions of dollars in the coming months. It would be worth paying some attention to what happens to these issues. It’ll give us useful clues about whether Indian companies can continue to pursue their global ambitions with the help of high leverage.

Your comments are welcome at cafeeconomics@livemint.com

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