A New Paradigm

Our last post dealt with the mechanics, or “financial engineering”, available to capitalists currently in which low cost debt can be used to improve return on invested capital (ROIC) by using debt to buy back or reduce outstanding shares (or equity capital). As we explained, the reason for this is the current arbitrage that exists between the cost of debt and equity capital.

In addition to repurchasing or reducing equity capital, availability of low cost debt capital can be used to acquire undervalued businesses. This is what happened in the 1980s in the great “leveraged buy out” (LBO) wave, which lasted from 1982-1989. During that period there was a significant number of corporate takeovers fueled largely by debt. Some of the larger examples of takeovers during that period included Beatrice Companies, Revco Corp, Jim Walter Industries, Federated Department Stores, Uniroyal Goodrich, and Hospital Corporation of America. Capitalists realized that these businesses were under-earning their cost of capital and through restructuring and re-capitalization of the businesses, ROIC could be significantly improved, hence greater return potential for equity holders.

We have something similar to the 1980s occurring in today’s environment. There are many large companies trading at historically low valuations relative to their cash flow potential. The technology sector, for example, is one in which there are a number of large companies trading at very low valuations relative to sustainable cash flow. This can cause a couple of things to happen both of which can be fueled using low cost debt: 1) acquisition of the undervalued companies through an LBO; and/or 2) restructuring and reduction of equity capital base to boost return to equity shareholders.

We believe we are in a “new paradigm” similar to the 1980s. M&A activity has increased in 2013 and is expected to increase further in 2014. Leveraged loans are rising significantly, providing significant capital to fuel this activity. There are a number of very recent examples of M&A activity among large companies including: Sysco merging with U.S. Foods; American Airlines merging with U.S. Airways; and Avago Technology merging with LSI. The combination of slow global and corporate top-line growth combined with continued access to low cost debt capital should enable this new paradigm to continue for several years. This new paradigm should also help to support valuations for public equities and provide fuel for further increases in stock prices.