Be
Careful Out There
John Mauldin
Michael
Lewitt, author of The Credit
Strategist, likes to get right to the point. Here’s the opening
paragraph of this month’s TCS:
Commodity prices are plunging, the dollar is
powering higher, the yield curve is flattening, ObamaCare is collapsing, global
trade is plummeting and terrorism is spreading across the globe. The high yield
credit markets are sending distress signals and 10-year swap spreads are
negative. Energy companies are going out of business faster than you can say
“frack” and trillions of dollars of European bonds are again trading at
negative interest rates. The world is drowning in more than $200 trillion of
debt that can never be repaid while European and Japanese central bankers
promise to print more money and the Federal Reserve is being dragged
kicking-and-screaming into raising interest rates by a paltry 25 basis points.
Accurate pricing signals in the markets are distorted by overregulation,
monetary policy overreach and group think. Hedge funds are hemorrhaging and
investors, desperate to generate any kind of nominal return on their capital,
continue to ignore the concept of risk-adjusted returns. Some market strategists
believe this is a positive environment for risk assets; I am not among them.
Michael
pays particular attention to the credit markets, and he doesn’t like what he
sees. He points out that corporate debt is now much higher than it was on the
eve of the financial crisis in 2007, driven by Fed-fueled leverage. This
leverage problem is really hurting the energy industry but goes far beyond it,
as Michael explains:
Companies in the United States have taken
advantage of low interest rates to issue record levels of debt over the past
few years to fund buybacks and M&A. This has driven the total amount of
debt on balance sheets to more than double pre-crisis levels. However, cash
flows have not kept pace, resulting in leverage metrics that are the highest in
10 years.
This
month’s issue of The Credit
Strategist is sobering, and I hereby forward it to you as this
week’s Outside the Box
– at the risk of putting you off your Thanksgiving dinner! Michael consistently
has one of the most well-reasoned perspectives in the Wide Wide World of
Finance, and if you’d like to consider subscribing to TCS, visit his website at
thecreditstrategist.com.
Richard Russell, RIP
I
was saddened this week to learn that my friend Richard Russell had passed away
over the weekend. He was 91. Dick was an icon of the investment analyst
industry. He launched his Dow
Theory Letter in 1958 and had writen the letter continuously ever
since. He became famous for his uncanny calls of the twists and turns in the
market. Early in the last decade he moved onto the Internet and began to write
a daily commentary, which had a wide and loyal following. The expanded space
gave him the opportunity to share his life with us. And what a life he had.
A
World War II combat bombardier, jazz enthusiast, raconteur; he could sit and
tell stories of his old Brooklyn neighborhood for hours. He recently noted the
passing of his last high school buddy, as one by one the old fighters from
World War II are disappearing.
The
Dow Theory Letter
is the oldest investment service written continuously by one person. He mentored
so many of us. I always enjoyed going to La Jolla and reaching out to Dick (and
his wife Faye), and we would have an early dinner somewhere. Even in his
mid-80s he felt compelled to get up early to study the markets so that he could
write, which meant early to bed.)
I
organized a tribute dinner for Dick about six years ago in San Diego. My
original thought had been to get together as many of the investment writers who
began in the ’80s and ’90s as possible and simply honor one of our own, before
he passed on and it was too late. Somehow, the evening morphed into a rather
fabulous and elaborate banquet for some 400 people from all over the world.
One
of the more amazing aspects of the event was Richard sitting at the head table
with all three of his wives and their four kids, and then working the room like
the Godfather of the industry that he was. Everyone was laughing and having a
great time. Along with all the personal tributes from the attendees, Mark
Skousen presented him with a book called Fifty
Years on Wall Street, which included tributes from his readers and
many compatriots in the business.
Dick
was a true believer in gold and diamonds, as well as dividend-paying stocks.
The diamonds were part of his Jewish heritage – he often told me that you can
put them in a small bag and take them anywhere.
During
his response that evening, he talked about the country, the markets, and the
future.
Although the following aren’t exactly his words on that occasion, they
are his words, and they do reflect what he said:
The end of capitalism will be due to the
unbelievable amount of debt that is currently being created. This will create
monster inflation that will destroy every currency. The only currency that
cannot be destroyed is gold. When investors realize this, we’ll have the
makings of the greatest bull market in gold ever seen.
He
sadly didn’t live to see that great gold bull market that he so passionately
believed in. Those of you who would like to read a note from his family can click here. You can read the tributes from the book we did
at this link.
As
I get ready to start baking cakes and otherwise preparing for the big gathering
tomorrow, there are so many things I’m thankful for. One of them is you and the
generous gift of your time and attention to my musings, which has given me a
life far beyond what I could have imagined 15 or 20 years ago. Perhaps, like my
writing hero Richard Russell, I will still be writing to you when I’m 90. And
you will still be reading.
Have
a great week and don’t forget, calories don’t count on Thanksgiving!
Your
getting his chef hat on analyst,
John Mauldin, Editor Outside the Box
Be
Careful Out There
“The high recent
valuations in the stock market have come about for no good reasons. The market
level does not, as so many imagine, represent the consensus judgment of experts
who have carefully weighed the long-term evidence. The market is high because
of the combined effect of indifferent thinking by millions of people, very few
of whom feel the need to perform careful research on the long- term investment
value of the aggregate stock market, and who are motivated substantially by
their own emotions, random attentions, and perceptions of conventional wisdom.”
– Robert Shiller, Irrational Exuberance,
Princeton, NJ, Princeton University Press (2000), p. 203
Commodity prices are plunging, the dollar is
powering higher, the yield curve is flattening, ObamaCare is collapsing, global
trade is plummeting and terrorism is spreading across the globe. The high yield
credit markets are sending distress signals and 10-year swap spreads are
negative. Energy companies are going out of business faster than you can say
“frack” and trillions of dollars of European bonds are again trading at
negative interest rates. The world is drowning in more than $200 trillion of
debt that can never be repaid while European and Japanese central bankers
promise to print more money and the Federal Reserve is being dragged
kicking-and-screaming into raising interest rates by a paltry 25 basis points.
Accurate pricing signals in the markets are distorted by overregulation,
monetary policy overreach and group think. Hedge funds are hemorrhaging and
investors, desperate to generate any kind of nominal return on their capital,
continue to ignore the concept of risk-adjusted returns. Some market
strategists believe this is a positive environment for risk assets; I am not
among them.
Investors continue to bid the prices of a select
group of mega-stocks to unsustainable levels while most of the market
experiences a stealth bear market. Market internals are terrible. The same is
true in the credit markets where CCC-rated bonds are badly underperforming
BB-rated bonds on a trailing 12-month total return basis (by 700 basis points
overall and 460 basis points ex-energy). This has only occurred three times
before – twice coinciding with developing credit crises in early 2000 and early
2008 and once in 2011 when the Fed kept markets afloat by announcing QE2. High
yield is now underperforming equities and investment grade debt simultaneously,
which is highly unusual considering that the asset class sits between these two
asset classes on the risk spectrum. The last time this happened was early 2000
and late 2007 – periods that preceded credit crises. Deutsche Bank remarks
that, “Last week [the week of November 16] was the best week for the S&P
500 since December 2014 but US HY continued to under-perform virtually all
major comparable asset classes... The big question within credit and to the
wider global markets community is whether this can be contained or whether it
is reflecting a turning and deteriorating credit cycle that is going to be
tough to stand in the way of.” (http://www.zerohedge.com/news/2015-11-23/how-possible-deutsche-bank-asks-noting-canary-junk-bond-mine)
While some argue that high yield market weakness
is primarily liquidity driven, careful analysis of company and industry data
suggest that poor fundamentals are at work. While early in the year these
problems were largely confined to energy and energy-related companies, weakness
has since spread to the media and retail sectors. The media sector sold off
over the summer and retail followed in the fall.
Highly leveraged companies in
all industries are unable to amortize the debts they have accumulated in the
years after the financial crisis. While their high debt levels were disguised
by record low interest rates arranged by the Fed, investors are finally waking
up to the fact that corporate balance sheets are more leveraged than they were
before the financial crisis in 2007. In an economy that struggles to grow at
2%, leveraged companies find it difficult to grow rapidly enough to service
their debts. They rely on the complacency of lenders who are tired of eating at
a restaurant that offers them small portions and lousy food. After years of
mid-single digit returns that do not compensate them for such lousy fare,
investors are starting to demand more, eating elsewhere, or going on diets.
The Real Story
About Corporate Debt
Goldman Sachs recently caught up to the
excellent work done by Andrew Lapthorne at Societe Generale regarding the
releveraging of Corporate America.
Mr. Lapthorne has been warning for more than a year that corporate debt is significantly higher than it was on the cusp of the financial crisis in 2007. (Andrew Lapthorne, Societe Generale Global Quantitative Research, “Quant Quickie: As US corporates pile on debt, leverage should now concern the market,” June 12, 2014.)
Mr. Lapthorne has been warning for more than a year that corporate debt is significantly higher than it was on the cusp of the financial crisis in 2007. (Andrew Lapthorne, Societe Generale Global Quantitative Research, “Quant Quickie: As US corporates pile on debt, leverage should now concern the market,” June 12, 2014.)
These higher debt levels have
been disguised by the low interest rates engineered by the Fed. Now Goldman
Sachs has confirmed Mr. Lapthorne’s findings, writing: “Companies in the United
States have taken advantage of low interest rates to issue record levels of
debt over the past few years to fund buybacks and M&A. This has driven the
total amount of debt on balance sheets to more than double pre-crisis levels.
However, cash flows have not kept pace, resulting in leverage metrics that are
the highest in 10 years.” (Goldman Sachs, Equity Research, “What’s Eating
Corporate America? Leverage, Goodwill and FX,” November 10, 2015.)
Goldman refutes the argument that low rates
render these higher debt levels innocuous: “Now, the counter-argument one hears
is that the cost of this debt has never been this cheap with the average
interest rate paid dropping from close to 6% to 4% in 2015. Put another way, as
debt has more than doubled, the amount of leverage expense has only gone up by
40%. This is all good until you normalize EBITDA. Indeed, if EBITDA was at
‘normalized levels’ (which we define as median NTM EBITDA from 1Q07- 2Q15),
leverage would move to 1.75x, over 30% higher than the average over the last 10
years.” Balance sheet health is further inflated by $1 trillion of goodwill
that has been added over the last ten years. This is the type of data that
investors should be focusing on rather than being fooled by phony non-GAAP
earnings adjustments, stock option accounting and stock buybacks that paints a
false picture of corporate health. The data on corporate leverage is another
reason why I believe the bull market ended late in 2014.
This leverage problem goes far beyond the energy
industry, which continues to fall apart in a manner reminiscent of the Internet
and telecom industry 15 years ago.
In mid-November, four energy companies owing
a combined $4.8 billion warned that their auditors had expressed doubts that
they could continue as going concerns – Penn Virginia Corp., Paragon Offshore
Plc, Magnum Hunter Resources Corp. and Emerald Oil Inc. The tens of billions of
dollars of capital that was lured into propping up the industry earlier this
year when oil rebounded to over $60/barrel during the second quarter is now
worth roughly 25% less with little prospect of rapid recovery (as we warned at
the time). Capital invested in companies that can ride out the cycle can be
recovered but investments in highly leveraged energy companies may end up being
written off. Now investors don’t want to touch anything oil-related (hedge fund
have ratcheted up their short positions in oil) and banks are trying to reduce
their exposure as the consensus has caught up to the reality that oil prices
are not going to recover for a long time (again, as we have repeatedly warned
since the oil collapse began last year).
Commodities
And speaking of commodities, with the dollar
trading at multi-year highs, the prospects for a recovery in commodity prices
are dim. Commodities trade in dollars and the strengthening dollar is
depressing their prices (more on the dollar below). But supply and demand
conditions are also contributing to the decline - and most of the trouble is
coming out of China. Several prominent investors, including David Tepper,
Daniel Loeb and John Burbank, recently echoed warnings that readers of this
publication have been reading all year that China’s economy is not going to
recover anytime soon. China is now engaged in depreciating its currency and
pumping out as many cheap commodities as possible to keep its broken economic
engine going, but all these measures will succeed in doing is dragging the rest
of the global economy down. I have written it before and I will repeat it again
– China is a house of cards built on a flimsy foundation of debt.
Counting on a Chine se economic recovery is a fool’s errand.
Counting on a Chine se economic recovery is a fool’s errand.
Aluminum
China’s surging exports of aluminum and steel
are crushing prices around the world. According to The Wall Street Journal,
China’s aluminum exports are up 14.4% this year. (The Wall Street Journal,
“China Exports Depress Aluminum Prices,” November 11, 2015, p. C3.) Prices
can’t seem to find a bottom. As of November 11, benchmark 3-month aluminum
futures were trading at around $1,492/ton on the London Metal Exchange, just
above a six-year low. Six years ago the world was in the midst of the worst
financial crisis in a century. By November 23, they had dropped further to
$1,439.50 per ton. China also appears to have no intention of cutting back its
exports. Chinese producers have added 3 million tons of new capacity this year
and could add another 1 million before year-end, forcing the Chinese market
into further oversupply and leading them to export more.
Copper
Dr. Copper is ailing as well and is also trading
at six-year lows. Copper prices have dropped 28% year-to-date. The December
copper futures contract in New York was trading at $2.2175/pound on November
10, its lowest closing price since July 2009.
The November contract also closed at a six-year low of $2.2165/pound on that date.
But matters deteriorated further after that. By November 23, the contract had dropped to $2.0210/pound.
The November contract also closed at a six-year low of $2.2165/pound on that date.
But matters deteriorated further after that. By November 23, the contract had dropped to $2.0210/pound.
China drives roughly 40% of world copper demand,
where it is used in construction and manufacturing. There is little chance that
other countries can take up the slack created by China’s economic slowdown.
Copper is a particular problem for Glencore PLC, which I have written about on
Sure Money (http://suremoneyinvestor.com/). Glencore, which is
struggling under a mountain of debt and plummeting commodities prices, earned
20% of its operating profit from copper in the first half of 2015. Moody’s
Investors Service believes that copper below $2.20/pound poses a potential
threat to Glencore, which is struggling to reduce the debt load it accumulated
in rosier times. While large producers have shut down some mines, others are
still completing expensive long-dated projects that are adding to global supply
and extending the downturn.
According to Barclay, four new mines will increase
world production by 5.1% next year.
Other companies feeling the pressure include Anglo American plc and Rio Tinto plc.
Other companies feeling the pressure include Anglo American plc and Rio Tinto plc.
Oil
Oil is testing the $40 per barrel (WTI crude)
level due to dollar strength and continued global oversupply. Investors poured
tens of billions of dollars into new energy investments during the second
quarter of this year when oil rallied back to over $60 per barrel. At least one
large credit fund run by Chicago firm Achievement Asset Management announced it
is closing down after being hurt by investments in energy bonds. According to
The Wall Street Journal, “Achievement, which had more than $2 billion under
management in mid-2014, is the largest hedge fund casualty to date from the
reversal of a trade that was supposed to carry the year for many star
investors. Many managers spotted an opportunity over the last year in
beaten-down debt from energy companies hit hard by oil’s slide.” (The Wall
Street Journal, “Chicago Hedge Fund To Close, Hit by Slide in Energy-Firm
Debt,” November 18, 2015, p. C3.) What these investors missed was the fac t
that a strong dollar would make it virtually impossible for oil to sustain its
mid-year rally even if industry fundamentals improved, which they did not.
Readers of this publication knew better. The energy downturn is going to last
much longer than people think; managers who fail to factor in currency and
other factors will continue to miss the mark and fail their investors. The
manager of Achievement should be commended for saying that he didn’t think it
was appropriate to run a “laboratory experiment” with his clients’ money. There
are too many Victor Frankenstein’s in this business already.
Legislators
Running Wild
The next time somebody tries to convince you
that legislators have memories longer than the half-lives of fruit flies, refer
them to the following two examples of epic stupidity.
The first is Fannie Mae and Freddie Mac rolling
out a new program called “Home Ready” that allows homeowners to obtain a
mortgage with a 3% down payment. In the third quarter, Fannie Mae’s profit fell
by 50% year-over-year while Freddie Mac reported its first quarterly loss in
four years. Both companies’ earnings were hurt by a decline in the value of
their massive derivatives portfolios. After the companies announced their
results, their government overseer, the director of the Federal Housing Finance
Agency Mel Watt, warned that they may require another government bailout.
The second involves the regulation of business
development companies (BDCs), a type of publicly traded closed end fund that
makes loans to small and mid-sized businesses. As of June 30, there were 88
active BDCs with net assets of $52.3 billion; the largest ones are affiliated
with large publicly traded equity firms. Currently, roughly 90% of BDCs are
trading below net asset value and can’t raise additional capital without
further diluting their stock price. In a move reminiscent of removing the
leverage caps on large broker dealers in 2004, which led firms like Bear
Stearns and Lehman Brothers to blow themselves up, Congress has decided in its
infinite wisdom to raise the limit on how much borrowed funds BDCs can use to enhance
their returns. Further, BDCs will be allowed to charge management fees on
levered rather than unleveraged assets. Finally, the legislation would allow
BDCs to increase their lending to opaque financial companies like banks,
brokers and insurance companies when they were originally intended to focus on
operating companies that provide non-financial goods and services. SEC Chairman
Mary Jo White testified against this legislation in Congress, warning that it
would significantly increase the risks of these funds for the retail investors
at whom they are aimed. Coming at the late stages of an epic credit cycle, this
is classic pro-cyclical legislation that can only lead to trouble.
Climate Change
and Your Investments
While politicians and political commentators
debate whether climate change is a greater strategic threat to the United
States than radical Islam or Vladimir Putin (it is not), investors need to take
the regulatory response to this issue seriously. While the precise impact of
climate changes is still being debated, two recent regulatory moves signal
potential trouble ahead for investors in industries such as energy,
industrials, autos and any other activity that politicians decide has a
negative effect on the environment.
The first move occurred in New York where
politically ambitious Attorney General Eric Schneiderman invoked the
controversial Martin Act to subpoena records of Exxon-Mobil going back thirty
years related to the oil giant’s response to and public statements regarding
climate change. News of the subpoena was leaked to The New York Times, which
reported on November 5 that the New York Attorney General had “begun a sweeping
investigation of Exxon Mobil to determine whether the company had lied to the
public about the risks of climate change or to investors about how these risks
might hurt the oil business.” The Martin Act was enacted in 1921 to prosecute
stock boiler rooms. It doesn’t require prosecutors to prove intent to defraud
and in this case would not require proof that any Exxon investor was harmed.
The law also doesn’t require probable cause to commence an investigation. The
Martin Act was a favorite tool of Mr. Schneiderman’s predecessor Eliot Spitzer.
One would think that the types of disclosures the AG is asking about fall within
the purview of securities regulators, not the state attorney general. I would
advise Exxon Mobil to the subpoena by informing Governor Andrew Cuomo that it
will begin moving as many of its offices and other facilities outside of New
York State as possible and by refusing to cooperate with this unlawful
investigation.
The second move came when the Department of
Labor issued new regulations on October 26 that affect the law governing how
fiduciaries manage pension assets. Amending a 2008 interpretive bulletin that
it now believes “unduly discouraged plan fiduciaries” from considering
environmental, social and governance factors in their investment decisions, the
Department of Labor issued new Interpretive Bulletin 2015-01 that now requires
managers to take such factors into account. Under the new guidelines, while
fiduciaries cannot accept lower return expectations or greater risks, they are
required take environmental, social and governance factors into account at
“tiebreakers” when all other factors are equal. “Environmental, social and
governance issues may have a direct relationship to the economic value of the
plan’s investment. In these instances, such issues are not merely collateral
considerations or tiebreakers, but rather are proper com ponents of the
fiduciary’s primary analysis of the economic merits of competing investment
choices.” Wall Street is objecting to this intervention into the investment
process by the government. By warning fiduciaries that consideration of the
environmental factors is required in cases where they have a direct impact on
the value of an investment, the Department of Labor is effectively intervening
in the investment process.
If an investment is in fact affected by climate
change and a fiduciary fails to factor that into the analysis, he or she could
now be deemed to be violating his fiduciary duty. On the face of it, there is
nothing unreasonable about including such factors in one’ investment analysis.
Investors are wise to consider whether companies are subject to environmental
risks, for example. The problem is that with the hammer of potential liability
hovering over their heads, this type of vague guidance could lead large fund
managers to start avoiding investments in sectors such as energy, utilities or
autos. Whether that will happen until the Department of Labor starts taking
action against fund managers for violating this new guidance remains to be
seen. But the guidance alone is a roadmap for political activists and their
attorneys to pressure pension funds to steer away from such investments. As I
write in my new book The Committee to Destroy the World, much of the law that
governs fiduciaries is outmoded in today’s world. Concepts such as the
efficient market hypothesis and diversification that govern fiduciaries have
been repeatedly discredited. The last thing we need is the government telling
investors what factors they should and should not consider when they allocate
capital. This is an inappropriate intervention into free markets.
The Disaster
that is ObamaCare
There is a reason that adults are told to don
their oxygen masks before assisting children in the event of an emergency on an
airplane. If the most capable people are disabled, the weakest are unlikely to
be able to help themselves. The same adage applied to the U.S. economy when
Barack Obama took office in January 2009. In the midst of the worst financial
crisis in a century, it was imperative that everything be done to address the
causes of that crisis and to strengthen the fabric of the economy to position
it for sustainable economic growth. That wasn’t done.
Instead, the president
made a historic decision that will rank among the great policy errors of the
21st century. Appealing to his political base, he decided to pursue healthcare
reform despite opposition from a majority of the American people and a
near-majority of Congress. He managed to sneak the legislation through by a
bare majority using a reconciliation process designed for budget items and sold
it as a phony civil rights measure. In the rush to pass the highly complex law
before losing his Congressional majority, neither the president nor the vast
majority of those who voted for the law read the bill or evaluated its
unintended consequences. The result, as you might expect, is the infliction of
enormous damage on the American economy and tens of millions of Americans whose
medical care has been turned upside down in the name of providing another
entitlement without asking anything in return of the recipients. ObamaCare has
increased medical costs, deprived Americans of their chosen physicians and
treatments, and contributed to a culture of dependency that has no place in a
land of liberty.
The law is also, predictably, a financial
shambles. Eleven of the 23 regional coops formed under the law have failed. The
largest health insurer in the country, United Health, warned that it may
withdraw from state exchanges after suffering hundreds of millions of dollars
of losses. We are also learning the true costs of the law’s expansion of
Medicaid to the states – and they are nothing short of catastrophic. While the
Obama administration thought it could conceal the true costs of the law by
pushing them off until after it leaves office, the chickens are already coming
home to roost. ObamaCare was designed to incentivize states to expand their
Medicaid programs by offering to pay 100% of additional costs through 2016,
dropping to 90% by 2020. This free money led many states to take what appeared
to be a great deal, but they are learning that there are no free lunches.
According to the Associated Press, at least 14
states have seen new enrollments exceed their original estimates, causing seven
of them to increase their cost estimates for 2017. California expected 800,000
new enrollees after the state’s 2013 Medicaid expansion but ended up with 2.3
million. Enrollment outstripped estimates by 44% in New Mexico, 73% in Oregon
and more than 100% in Washington. Illinois, which is already hopelessly
bankrupt, originally projected that its Medicaid expansion would costs $573
million for 2017-2020; but 200,000 more people enrolled than expected and the
cost has increased to about $2 billion. Where the state is going to come up
with this money is anybody’s guess.
Enrollment overruns in Kentucky (which just
elected a Republican government who promised to end the Medicaid expansion)
forced officials to double their estimates of the cost for 2017 to $74 million
from $33 million and the figure may rise to $363 million in 2021. Ohio , home
of presidential candidate John Kasich, has seen state spending on its Medicaid
program grow by $5.8 billion since 2011. It now projects the total cost of its
Medicaid program to hit $28.2 billion in 2017 – a 59% increase during Mr.
Kasich’s tenure.
Why is this important? Among other things,
states have to balance their budgets by law. If their Medicaid budgets are
blowing up, they are going to have to make sharp cuts in other areas or raise
taxes significantly. Municipal bond investors are going to have to pay special
attention to deteriorating credit quality in states that decided to enter the
Devil’s Bargain known as ObamaCare. This law is profoundly flawed and is going
to have to be repaired or repealed before it completely destroys the American
healthcare system.
Private Equity
Never Learns
While most of the big busted LBO deals of the
mid-2000s have been flushed from the system, the private equity industry is in
the process of repeating its past mistakes on a smaller scale as we reach the
terminal state of the current credit cycle. Standard & Poor’s recently
released a report warning that the recent crop of LBOs faces mounting credit
risks as a result of too much leverage, rising borrowing costs and slowing
economic growth. (Standard & Poor’s, “Why The Recent Crop of Leveraged
Buyouts Faces Mounting Credit Risks,” November 3, 2015.)
The number of buyouts has dropped sharply since
the mid-2000s. The peak came in 2007 when 434 of these transactions were done.
Since then, the highest number of LBOs was 164 in 2013; 119 were done in the
first nine months of 2015.
Alarmingly, however, the average EBITDA multiple has
increased sharply in recent years to a record 11.2x in the third quarter of
2015. By way of comparison, however, 2014 (9.7x) and the first nine months of
2015 (10.3x) saw EBITDA multiples that were as high as the 9.7x multiple paid
in 2007, the top of the LBO bubble. Pro forma LBO leverage has also crept up to
5.7x in 2014 and 5.6x in the first nine months of 2015, approaching the 6.1x
level seen in 2007. New deals have taken advantage of looser creditor
protections as evidenced by the explosion of covenant-lite bank loans, which
hit a new record volume of $66 billion in 2014. In many cases, covenant-lite
bank loans are bank loans in name only; they do not possess greater covenant protect
ions than bonds and are a sure sign that lenders have reached what my friend
Doug Kass would call “peak complacency.” (I wrote about some of the ridiculous
covenants that bondholders and bank lenders have agreed to extend to buyout
firms in my chapter in the new book Martin Fridson, editor, High Yield Future Tense: Cracking the
Code of Speculative Debt, New York, New York Society of Securities
Analysts, Inc., 2015. See Michael E. Lewitt, “The High Yield Bond Market: A
Tale of Boom and Bust.”)
Naturally, LBO sponsors are exiting LBOs at a
rapid clip and are now sitting on more than $500 billion of dry powder just as
stock prices are trading at high valuations that offer little value for buyers.
This has already been apparent in the double-digit multiples paid over the last
couple of years. The fact remains that, for the most part, private equity
consists of substituting debt for equity on the balance sheets of perfectly
healthy companies; it is an activity that contributes little to the productive
capacity of the economy, to social welfare or to economic growth. Its
risk-adjusted returns are also not all that great except in the hands of a
limited number of practitioners. Investors can now look forward to poor returns
and potentially significant losses on the deals done at ridiculously high
multiples over the last couple of years.
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