Is it starting to happen now? We continue to believe that the main source of stock market levity is the mammoth buyout activity, which is financed by sliced and diced loose corporate loans (Collateralised Loan Obligations) and junk bonds that are issued by the company being privatized (a debt for equity swap). One well- respected market pundit stated that stock prices would be 20 -25% lower if not for the buyouts of public companies.But this financial alchemy can’t go on indefinitely.

In his July 20^thMarket Shock article, Floyd Norris states, “The great stock market rally of 2002 through 2007 has been built on liquidity — and much of the liquidity has been based o n financial engineering that allowed highly risky investments to be financed by investors who thought they were taking no risks.They were wrong.”
 

Recently, subprime mortgage problems (fears of default) and the huge amount of buyout financed debt in the pipeline - estimated at over $200bn in the US alone - has finally started to spook lenders, who are beginning to reject many of these shaky deals.Several leveraged loan and junk bond financings for LBOs have been pulled or restructured in recent weeks, including US Food Service, Chrysler, Dollar General, ServiceMaster and Thomson Learning.Last week, ABN Amro and Citigroup pulled the plug on the 925M Euro debt package, backing the refinancing of Dutch DIY retailer Maxeda.
 

US Foodservice postponed its high-yield bond offering, citing adverse market conditions. The pricing on the deal had been revised upward before being pulled. The junk bond offering for Dollar General also received significant resistance.That led to Kohlberg Kravis Roberts (KKR) offering tighter covenants and a higher interest rate.
 

Buyout firm Cerberus Capital Management has been planning to launch the financing for the Chrysler deal this month. The debt package is ultimately expected to total $62 billion and we wonder if lenders will balk at the terms.For more info:
 

http://blogs.wsj.com/deals/2007/07/10/first-data-chrysler-financing-just-got-trickier/
 

The$44bn buyout of TXU and $26bn buyout of First Data, haven’t come to market yet (details below).The proposed buyout of TXU is by Texas Energy Future Holdings - a Limited Partnership consisting of KKR, TPG, Goldman Sachs and others.KKR is the sole sponsor of the First Data deal.For further info:
 

http://www.dallasnews.com/sharedcontent/dws/img/06-07/0624txureport.doc

http://content.lawyerlinks.com/default.htm#http://content.lawyerlinks.com/sec/deals_m_a/first_data_buyout.htm
 

Yet KKR co-founder George Roberts recently stated that returns from leveraged buyouts will decline. “The coming years will be harder, no question.Returns will fall significantly,'' Roberts told Germany's Manager Magazin.So much for the “Golden Age of private equity,” which Kravitz proclaimed this April.
 

In a July 23^rdWSJ article, A Short-Lived Golden Age, Breaking Views states, “Credit spreads have widened, conditions on new leveraged-buyout loans are tighter, and banks are finding it hard to shift $40 billion of LBO debt for the likes of Chrysler and Alliance Boots PLC, the U.K. retailer. Even the enthusiasm for emerging markets has faded: OAO Rosneft, the Russian oil giant, earlier this month pulled a $2 billion bond offering.”
 

A related article, Is Kravis’ Golden Age Turning to Bronze?, may be accessed at:

http://blogs.wsj.com/deals/2007/07/19/is-kravis-golden-age-turning-to-bronze/
 

Will the stress from the tougher LBO lending conditions coupled with the subprime mortgage meltdown spill over into the junk bond market?There is a huge amount of junk bond offerings in the pipeline and we wonder if all of them will be successfully placed (in spite of low default rates).If a significant number of the junk bond backed buyout deals do not get done, a huge driver of equity prices would be eliminated.Widening credit spreads, caused by falling junk bond prices (due to huge supply), will also dampen enthusiasm for debt financed takeovers and buyouts.If so, the stock supply-demand balance might then return to normal and equities would no longer benefit from the buyout boom.
 

When buyout activity grinds to a halt, what do you think will continue to buoy equity prices? Our answer:NOTHING.Look out below!
 

The Curmedgeon