The leveraged buyouts that have fuelled record merger activity face a new test as interest rates rise and stock markets wobble, early signs that the debt behind the deals could become more costly and difficult to raise.
Low interest rates around the world have led to an explosion in buyouts by private equity firms such as Kohlberg Kravis Roberts and Blackstone Group in recent years.
They have been able to take on more ambitious deals seemingly by the day, such as the record European buyout of pharmacy chain owner Alliance Boots, as funding costs hit the sweet spot: relatively cheap from a borrower's point of view, but relatively high from a lender's perspective.
But as hopes of U.S. interest-rate cuts fade with the Fed focused on inflation, government bond yields have surged higher, pushing up funding costs for buyers and making less risky debt a more attractive prospect for bond investors.
Ten-year U.S. Treasury yields broke the psychological 5% barrier to hit a high of 5.25% on Friday, up 28 basis points from Wednesday, before retreating to 5.14%.
The turmoil that sharp move has created forced retailer Edgars Consolidated Stores, bought by Bain Capital in South Africa's largest ever LBO, to pay 125 basis points more than initially planned on one segment of its bond financing and to scrap a fixed-rate bond sale.
So is the LBO rush, which has helped support stock market valuations, drawing to an end?
"We are aware that markets are very toppy, and this can't go on forever," said Guy Eastman, the European investment director for private equity investor SVG Capital Advisers. "We are expecting things to get tougher."
But he said he wasn't certain the recent fears of global interest rate hikes would mark the peak of the LBO boom, and said it could just as easily be a geopolitical event as an economic one that turns the market.
"It's a very micro question as to what does a percentage point rise in interest rates mean to investors, but the impression we pick up from the markets is there are some deals out there that have been very finely priced and a rise in rates may not be brilliant for them," Eastman said.
Not Changing The Equation
Martin Thorneycroft, head of European high-yield capital markets at Morgan Stanley, said it was too early to tell whether the sharp rise in yields would have a long- or medium-term impact on the attractiveness of private equity buyouts.
"If government yields stay where they are or rise further, it will have an impact on the cost of financing for non-investment-grade borrowers, including LBOs," Thorneycroft said.
"But at the moment we're still talking basis points: a 50-basis-point increase in yields on 1 billion euros of LBO debt is worth 5 million euros a year in additional interest cost. It's meaningful, but I don't think it's enough at this point to change the equation."
And there is one significant factor that hasn't changed; the need for private equity firms to put money to work. They are expected by analysts to raise another $500 billion of funds this year.
"There was almost 200 billion euros of fresh cash raised by the European private equity community in the last two years," Tom Attwood, managing director at Intermediate Capital Group, a specialist lender to buyout firms, said in comments published on the firm's Web site this week.
"That's by no means all spent. There's this huge cash overhang. So ... we don't see it stopping in the near term."
And while underlying rates like Treasury yields and Euribor are rising, high-yield bond spreads remain tight, according to data from Merrill Lynch indexes, at 190 basis points over government bonds on June 6. In June 2005, they stood at 414 basis points.
A survey of investment-grade credit investors by JP Morgan published on Friday also found that 36% of respondents see central bank rates as the greatest risk to credit market performance for the rest of the year.
But the survey also showed that 34% see private equity as the biggest risk for credit -- suggesting that they fear the LBO bandwagon is set to roll on.