Ebook Did Structured Credit Fuel the LBO Boom?
The past few years have witnessed a dramatic boom and the bust of highly levered transactions such as leveraged buyouts (LBOs). From 2004 to 2007, $535 billion of public-to-private LBOs were completed, more than ten times the $50 billion of LBO volume over the combined previous eight years from 1996 to 2003 (Figure 1). This recent LBO boom eclipses the 1986-1989 boom where completed LBO volume reached $137 billion. The collapse of the recent LBO boom was as dramatic as its rise, with LBO volume dropping by 94% in the fourth quarter of 2007 from prior year levels.
This enormous rise and spectacular collapse cannot be explained by trade-off theories of capital structure. In the trade-off framework, LBOs are thought of as creating value by increasing interest tax shields or lowering agency costs. However, these benefits are unlikely to vary as sharply over time as observed LBO volumes. In this paper, we examine the role of the supply and pricing of credit from structured credit markets to understand their effects on LBO transactions.
The LBO boom coincides with important developments in the structured credit markets that substantially increased the supply of credit. We argue that these developments, notably the expansion of the market for collateralized debt obligations (CDOs), had a substantial impact on the LBO transactions and how these transactions were funded. As investor demand for CDOs increased, CDO issuers needed more collateral assets to issue CDOs, providing banks with incentives to originate loans used to fund LBOs that could be placed in CDO vehicles. We argue that this easier access to credit led to more highly levered transactions such as LBOs and increased the amount of debt used in these transactions. We suggest that these forces led to the increased frequency of LBOs and to larger loans provided to support these transactions.
We consider several questions arising from these credit market developments. How did the growth of the CDO market affect banks’ lending policies? Did the ability for banks to sell loans through CDO distribution channels lower their screening incentives and lead to more loans to lower quality issuers? How did this increased availability of credit affect the incentives of management and financial sponsors that structured the LBO transactions? Did the easier access to credit lead to riskier LBO deals?
The goal of this paper is to examine how developments in credit markets affect the supply of credit and their impact on corporate investment and capital structure decisions. Much of the literature has focused on demand-side firm characteristics related to taxes, agency problems, information asymmetry, and bankruptcy costs to understand these decisions, but less is known about the role of supply-side factors. Recent papers by Faulkender and Petersen (2006), Sufi (2009), and Lemmon and Roberts (2008) examine supply-side effects in capital structure decisions. We extend this literature by studying the role of supply-side effects on the M&A market, the structure of transactions, and the attributes of deals. The LBO market is well suited to study these issues because the extensive use of debt in these transactions makes it very sensitive to changes in credit supply.
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