Deutsche Bank Predicts New LBO Upcycle
Here we go again. Brace yourself for another leveraged buyout boom. Deutsche Bank lays out in detail why it believes we are “on the cusp of another LBO upcycle.”
By Stephen Taub
Here we go again. Brace yourself for another buyout boom. In a
36-page report sent to clients earlier this week, Deutsche Bank
laid out in detail why it believes we are on the cusp of
another LBO upcycle. Im not sure whether this is
good or bad news.
If Deutsche Bank is right, it will mean M&A activity can
help revive the sagging, sullen stock market. But, as we know
from the late 1980s as well as from just a few years ago, these
booms end ugly. Valuations are heavily marked down literally
overnight. Would-be acquirers try to renege on agreed upon
deals. Shareholders of likely target companies suddenly are
saddled with big paper losses.
The biggest winners are usually the lawyers who argue whether
or not some Materials Adverse Change really took place at the
target or whether buyers remorse has stricken at the same
time that valuations were suddenly marked down. But, why jump
the gun before the fun has begun, right?
In any case, here is DBs case for the next LBO upcycle:
It starts with the fact there is currently $500 billion in
uninvested private equity capital. If you factor in typical
leverage used in these deals, this works out to $1.5 trillion
in purchasing power. Meanwhile, credit markets are robust,
equity valuations look attractive and corporate fundamentals
strong, Deutsche Bank asserts in its report. In our view,
each driver of an LBO IRR [internal rate of return] is
remarkably favorable at this time, the report adds.
It cites: high available leverage, lower required equity;
record low high yield interest rates; very high free cash flow
yields; strong cash flows; potential sales growth in a baseline
of economic recovery; a supportive environment for margin
improvement; and room for multiple expansion. One caveat:
The size of the last LBO boom could prove difficult to
repeat with capacity for mega LBOs likely lower. This is
actually good news.
So, who are the likely targets? Deutsche Bank singles out 50
companies. They all share similar general key attributes:
positive FCF, low margin, low asset growth, cheap valuation.
The bank came up with the list and criteria after analyzing 500
LBOs since 1986. It says a company must have positive free cash
flow to support additional debt, for example. Stocks with net
income margins below the industry group median provide a
financial buyer with the opportunity to cut costs and raise
profits, DB adds.
Finally, LBO firms must not require significant investment, it
adds. Hence, the low asset growth. Overall, these three
filters produced a universe of solid LBO candidates, it
asserts. DBs hit list of 50 M&A targets is rebalanced
monthly. DB says it has seen 11 acquisitions and has
significantly outperformed the S&P 500 since inception.
Based on back-testing, it claims an investor buying the top 50
LBO candidates in the S&P 1500 based on its criteria
generated 24 percent average annual returns since 1992, beating
the S&P 500 by 15.6 percent and the Russell 2000 by 13.5
percent. Nice. In addition, the Sharpe ratio of the basket is
higher than the S&P 500.
DB then rebalances the portfolio monthly. Among the current
50-stock list, there are a number of familiar names. They
include publishing giant Gannett, retailers Kohls and
Gap, drug maker Forest Laboratories, and defense giants
Northrop Grumman and Raytheon. Of the 50, five stocks are
currently on Deutsche Banks Buy list: Apollo Group, best
known for its University of Phoenix subsidiary; insurance giant
Cigna; Alaska Air Group; hard drive maker Western Digital, and
utility American Electric Power. Well be tracking this
list closely to see whether DB is on to something.