Higher interest rates are making an increasing proportion of potential LBO deals look unprofitable. That's what The Wall Street Journal [subscription] reported last Friday.
Up until last week, the stock market seemed to be rising because low interest rates made private equity deals attractive. And with so much money available to remove the supply of equity from public investors, stocks rose because of the Private Equity Put -- the perception that private equity investors' liquidity and willingness to take stock out of public shareholders' hands created a floor underneath which stock prices would not fall.
With Alan Greenspan now making headlines on behalf of his business rather than the Fed, the Private Equity Put had replaced the Greenspan Put -- the perception that the Fed's ability to manage interest rates and the economy created a floor underneath which stock prices would not fall.
With $250 billion worth of junk bond deals in the pipeline to finance takeovers, the increase in interest rates -- 10-year Treasury notes yield 5.1%, their highest level in 10 months -- means that the spread is narrowing between what private equity investors can earn on their investment and what it costs to finance their deals.
As I pointed out in a June 1 post, the fuel for deals was the widening gap between company earnings yields and the cost of borrowing. For example, estimated profit at S&P 500 companies represented a yield of 6.53% at the end of Q1 2007, when 10-year U.S. Treasuries yielded 4.65%. The 1.88-percentage-point advantage was the biggest since at least 1986. As of May 31st, the gap totaled 1.24 percentage points. With 10-years now yielding 5.1%, this spread has further narrowed.
Meanwhile corporate bond investor's tolerance for risk had reached record levels. In recent weeks, the additional interest that even the riskiest corporate bonds pay over Treasuries had fallen to a record low. This "spread," which is a proxy for investors' appetite for risk, was at around 2.5 percentage points last Friday. It was at 3 percentage points at the start of 2007, while in 2002 it stood at more than 10 percentage points.
If these institutional investors demand higher compensation for risk -- through higher interest rates -- they are not likely to keep financing all these private equity deals. This could lead to the unwinding of the Private Equity Put.
The result? Institutional investors would sell stocks. This would cause stocks to drop and corporate earnings to shrink as higher interest costs took a bigger bite out of profits. As a result, the market's current P/E of 18 -- though low by the standards of previous market peaks -- would look high relative to earnings growth.
And the basis for a rising stock market would fall through the now termite-eaten floor boards of the Private Equity Put.
Peter Cohan is president of Peter S. Cohan & Associates, a management consulting and venture capital firm. He also teaches management at Babson College and edits The Cohan Letter.
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