LBOs Out on a Limb, With Cyclical Breezes Blowing : Markets: This month’s panic was a strike against a financial sector that seems to push too hard for more borrowing.
The 1987 stock market crash occurred while the world’s central banks were busy propping up the dollar, thereby applying tremendous pressure to push up U.S. interest rates and cool an overheating economy.
This month’s Friday the 13th panic was superficially a muted version of the 1987 crash, but the fundamentals were very different.
After April, 1988, the Federal Reserve began to withdraw some liquidity from the U.S. banking system, resuming its attempt to slow inflation. The Fed’s effort kept interest rates at a higher level, drawing in billions of dollars of capital from abroad. The attraction of U.S. capital markets has become so strong that so far in 1989, central banks have spent $50 billion trying to keep the dollar from appreciating.
At the end of September, frustrated by what they considered a “too strong” dollar, finance ministers of the industrial democracies tried to engineer a further drop in the dollar. After two weeks of concerted dollar selling, they gave up--and tried to underscore their determination to weaken the dollar by raising interest rates in Europe and Japan.
Now comes the interesting part that precipitated the 7% stock market plunge on Oct. 13. The U.S. stock market has for the past year been driven almost exclusively by leveraged buyouts and rumors of leveraged buyouts. A leveraged buyout occurs when a group of outside investors offers to buy up the stock of a company with money raised by issuing junk bonds. Junk bonds carry high yields because they are riskier than government bonds, which yield about two-thirds as much. Since the interest on junk bonds is deductible, some companies find it attractive to switch from stock or equity financing to debt financing.
The first firms subject to LBOs were not so vulnerable to cyclical forces and therefore were better able to bear the risk of a constant need to pay interest on high-yield bonds. Typically, companies dealing in food or other staples were good candidates.
As the stock market was coming back after the 1987 crash, awash in liquidity provided by central banks understandably anxious to avoid a 1929-style debacle, the best takeover candidates were snapped up. Lately, takeover managers have turned to riskier, cyclical companies like UAL, Resorts International, Hilton, the Campeau retailing empire and Ramada Inns. As far as the takeover artists were concerned, these companies had a lot of equity on their balance sheets and therefore were good targets for leveraged buyouts financed by junk bonds.
But by late summer of 1989, things began to change. Signs of a weaker U.S. economy began to appear. The Group of Seven’s attempts to push down the U.S. dollar in the foreign exchange markets eventually resulted in higher interest rates in Europe and Japan. Leveraged buyouts began to run into difficulty late in September. On Oct. 13, the leveraged buyout deal for UAL was put on hold by American and Japanese banks. Stock traders decided to sell some of their exposure, a perfectly normal response to difficulties with LBOs. However, late on Friday afternoon, no one was willing to buy the shares of UAL, and in the ensuing panic the stock market dropped by almost 200 points, or 7%.
The American and Japanese banks, with some coaching from our Federal Reserve and Japan’s Ministry of Finance, had decided that they did not want to push aggressively on a deal that involved a sharp increase in borrowing in a highly cyclical industry. Many felt that the U.S. economy was headed for a recession or at least sharply lower profits. Further, it turns out that American money-center banks now have more exposure to junk bonds than they do to Third World debt. Memories of the painful experience with that debt no doubt prompted top management in American banks to back away from the UAL deal and other similarly shaky leveraged buyouts.
Friday the 13th provided a chilling reminder of the reason why cyclical companies don’t have much debt on their balance sheets. When the economy slows down, they probably won’t be able to make interest payments.
The panic was strike two against a financial sector that seems to take its turn at bat as an opportunity to push too hard for more borrowing. The LBO wave has performed a service by restructuring some balance sheets and keeping management on its toes, but for now it is largely over.
We had better hope that, while pulling itself back together, the financial sector does not start setting itself up for a third strike by pushing too hard for more debt financing. If that happens, we will be headed for a global market crash that won’t be over until the financial sector of the world gets around to reconnecting itself with the real economy.
