What’s driving the buyout comeback?

Apr 23, 2014

The buyout windfall

FORTUNE -- Buyouts tend to come in waves. The first arrived in the 1980s, when a series of high-profile leveraged buyouts shook the corporate world. Buyouts surged again in the mid-1990s, the late 1990s, the early 2000s, and around 2006.

In peak years, there were nearly a hundred buyouts -- in off years, as few as 10. The 2008 financial crisis is a striking reminder of this boom-bust feature of buyout markets. At the bottom of the market in 2008 we counted as little as 10 deals; the value of these deals was also low at 48 basis points fraction of total stock market capitalization.

As the economy recovered, we have seen a resurgence of buyouts with a value of 126 basis points of the market in 2010. Spectacularly, the once rare "megadeals" seem to be back. Both Heinz and Dell were moved from public to private markets that year, and both transactions each reached the $25 billion mark.

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These developments raise broader questions: Why should buyouts follow a boom-bust pattern? And what are the conditions that cause buyouts to surge one year and plunge the next?

Financial observers, including many academics, assumed credit markets drove buyout cycles: When credit is cheap, private equity firms and other investors have plenty of money to spend acquiring companies. When credit is tight, money for buyouts dries up.

Several years ago, I decided to examine buyout cycles more closely. I wanted to test whether the commonly held assumptions were correct. With two other researchers, Valentin Haddad of Princeton and Matthew C. Plosser of the Federal Reserve Bank of New York, I analyzed over 30 years of buyout data, from 1982 to 2012. We looked for patterns that might link buyout activity to other economic activities, including shifts in credit markets and movements in the economy.

We first developed an analytical model to generate hypotheses and to help us make sense of the data. Then we examined the buyout data in the context of the model. After completing our analysis, we found little support for the notion that credit markets drive buyout activity. (For the full study, click here.) Indeed, we determined that no more than 6% of buyouts could be attributed to credit conditions.

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We did, however, find considerable evidence linking buyout activity to economic indicators that tend to align closely with the strength of either the overall economy or the stock market. The strongest correlations were with the risk-free rate and the risk premium, which are two key components of aggregate discount rates. Aggregate discount rates usually provide a fair and accurate representation of the strength of the economy. Our analysis found that nearly a third of all buyouts could be explained by these indicators.

It makes sense that a strong economy and corporate buyouts would go together. When the economy is in good shape, investors tend to be confident they can improve performance of a target firm, achieve higher cash flows, and upgrade the target's valuation. When executing a buyout, investors have to tie up resources in illiquid assets -- an approach that is more attractive in a strong economy.

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On the other hand, when the economy is weak or volatile, investors are less confident they can improve a target firm's value or improve performance. At the same time, the cost of having an illiquid portfolio is high. These are conditions that discourage investors from pursuing buyouts.

When the financial crisis and recession hit, buyout activity fell sharply in the United States. But in the last few years, buyouts have made a modest comeback -- a trend that corresponds rather closely to the recent modest improvements that we have seen in the overall economy.

Erik Loualiche
is an assistant professor of finance at the MIT Sloan School of Management.

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