Outlook 2008: LBO, M&A activity - slowed in second half 2007 - still seen strong for 2008

By Ronda Fears

Memphis, Dec. 31 - Buyout and merger activity in 2008 is expected by many market participants to remain relatively strong in 2008, despite suffering a big setback in 2007 from a brief downturn in equities and the credit crunch that drained liquidity.

Corporate balance sheet strength and relatively cheap stocks should bolster M&A activity regardless of the expected continuation of the credit crisis, sources surmise. On the credit front, according to various sources, in 2007 the high-yield market saw spreads balloon by as much as 350 basis points while investment-grade markets saw a similar 280 bps spread widening.

Thus, many say a bigger equity component will be necessary for mergers.

"I don't think it will be as damaging as people think," a sellside arbitrage trader told Prospect News, although he expects buyout activity in 2008 to be half or less than 2007.

"The best thing that's going to come of all this is more stock-for-stock deals," the arb trader remarked.

Federal Reserve actions - lowering interest rates, special financing and regulated mortgage rates - are expected to have little impact on leveraged buyouts, although creative financing in the way of structured products are seen coming.

The breakdown in liquidity and credit markets is a repeat of what happened in the 1990s, another sellside equity trader commented, but "the cleanup process seems to be happening a lot quicker."

The Washington Mutual situation is an example of that, he said, referring to the Seattle lending institution's mid-December news that it would leave the subprime lending market, slash its dividend by two-thirds and make a $3 billion convertible preferred stock offering.

Many traders seem to agree that LBOs could take a gigantic hit but still make a very decent showing since figures for 2007, while not final, clearly show that it was another banner year. He said Dealogic reports that in 2007 through the end of October some $630 billion in LBOs had closed, well past the previous record of $467.5 billion in 2006.

The degree that M&A relies on leverage, which drove the frothiness of 2007, is another key factor in how 2008 will play out.

Jeffrey Saut, head equity strategist at Raymond James and Associates, remarked that M&A is merely seeing some pains from rationalization, like the technology craze and many other boom cycles that got out of hand.

As of year-end, he observed that "the M&A business to a large degree has ceased."

"I am entering 2008 much like I did 2007, in a very cautious mode," Saut said, noting that Raymond James' aggressive fund turned out a 35% gain for the year and its more conservative fund showed a 15% increase.

"We're up because we were cautious and took some opportunities."

In mid-August he agreed with many market players that the stock market trough was hit, but now Saut thinks that August low may be retested.

Mergers strong as stocks fumble

Strong corporate balance sheets and the so-called "decoupling" of the stock markets from the credit markets in August is in large part why many think mergers will proliferate through the coming year.

Strategists at four of the top investment banks are predicting a gain of 10% for the broader stock markets in 2008.

Through mid-December, the Dow Jones Industrial Average was running about 4.8% ahead of 2006, after hitting a record 14,400. At that time, the Nasdaq was running about 8% ahead of where it opened and the S&P 500 was running about 6.3% ahead of 2006.

Most traders Prospect News talks to and several bankers, however, are expecting that there will be some rough waters for the stock market in the first half of 2008.

"There really was no Santa Claus rally and I think that it's going to be tough for January, too," said a sellside stock trader at a mid-tier investment bank.

"The futures and options markets are telling us there is a strong negative bias out there."

"To be sure, more pain is headed our way," the head equities trader at a bulge bracket firm remarked to Prospect News.

"Unless you that the mark-to-market pain will aid and abet a recession, which will thereby produce a double-digit decline in corporate earnings, the credit derivatives problems of yesterday and today are fast becoming old news. And old news does not move markets. New news does. The new news is the progress made toward reinventing the magic formula, so everyone breathes a sigh of relief."

Credit imperviousness key

Immunity to the credit markets could be key for LBOs, though, a third sellside stock trader said, adding that most folks see that side of the equation worsening in 2008. Few onlookers think the mortgage reset debacle is close to being over, and many think the injuries will continue to spread into the broader mortgage market and big banks.

"There is no doubt that the widening in spreads hurt LBOs," the trader continued.

"But there doesn't seem to be a shortage of funds for private equity. They are still finding investors for new funds and I don't see that drying up over the next year."

According to a recent survey by Grant Thornton, bank, hedge fund and private equity executives expect the credit crunch to last well into 2008 and beyond, resulting in a slowdown in buyout activity and a decline in private equity returns.

The trader noted, however, that for 2009 and beyond, Hedge Fund Daily found institutional investors around the globe are predicting a major increase in allocations to hedge funds, and leveraged buyouts remain the most popular PE strategy, with nearly three-quarters of those hedge funds targeting LBOs.

Many pundits don't think the subprime mortgage fiasco, despite intervention from the Federal Reserve and others, will hit a bottom until 2009. Most still expect the subprime bleeding will extend deeper into the more mainstream financial community.

Activity in the credit markets, including loans, is expected by most to continue to slide in 2008, in part due to a less-accommodating attitude toward mega LBOs.

Real estate and homebuilding sectors will track the mortgage industry, the above trader thinks, despite the Federal Reserve quarter-point rate cut on Dec. 11 and a move to freeze mortgage rates for "troubled" homeowners.

Creative financing a big factor

Bankers remain perhaps the most confident despite the profound impact that subprime mortgage defaults have had on their bottom lines.

"Financiers are resilient and very creative," one banker at a top investment bank told Prospect News, on condition of remaining anonymous.

He noted that after the collateralized debt obligations market crashed in the second half of 2006, bankers at ABN Amro stepped up with the advent of constant proportion debt obligations that are designed to be less risky than a CDO. He expects that sort of creative financing will continue to develop.

But, then, he also noted troubles among structured investment vehicles, some created by big banks.

An SIV borrows money from investors on a short-term basis at a fairly standard rate and then invests that money in securities that pay higher interest rates. The profit spread is thin but typically involves large amounts.

But with credit spreads ballooning in 2007, the strategy backfired for many SIVs. For example, Citigroup Inc. said in mid-December that it would absorb its $49 billion SIV and, since then, Citi was said to have sold off about $15 billion of those SIV assets.

The Fed can't touch PE firms

Just as many investment pros say the Fed can't stop the bleeding at the financial institutions, sources say Fed actions are not considered to be a huge factor in arranging mergers and buyout financing.

"The Fed rate cut went over like a lead balloon," said a private equity official who spoke to Prospect News on condition of remaining anonymous.

"The market looked like it had already priced in a quarter-point cut but that was seen as a half-measure. They wanted a half-point cut.

"Mega deals are maybe impossible right now," he said, "but, overall, private equity has plenty of other tricks and adapts deftly to a changing environment."

In addition to the rate cut and mortgage rate freeze, the Fed also established a temporary Term Auction Facility and an Overnight Indexed Swap - foreign exchange swap lines with the European Central Bank and the Swiss National Bank that swap a floating-rate interest payment rolling at the overnight Fed Funds rate for a fixed payment over a certain term, which for the purpose of the new Fed auctions is close to one month.

Distressed names prime targets

Distressed names are presenting a new frontier for private equity, as well, the PE official remarked.

Recently, he said default rates have been slightly lower, although he actually expects 2007 to show a 3% gain and he sees that climbing by 5% in 2008. Rating agencies have observed the same phenomena and also expect the default numbers to rise in 2008.

"From our point of view, that means availability [of buyout opportunities] will get better," he said.

He specifically mentioned the recent $50 million loan purchase for American Home Mortgage Investment Corp., a bankrupt subprime mortgage lender, by big private equity player WL Ross & Co. LLC.

"This is only the beginning of massive opportunity," for PE to pick off distressed names with clear and sound business models. He does admit, however, that there will be pain for some in the next few months.

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