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So many deals, so little time
Author: Price Headley (info)
Website: http://bigtrends.com
Posted: July 27th, 2007 at 1:00 pm EST
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Over the past year we have seen an explosion in mergers/acquisitions. Many of these deals have been made by companies in the same field, others have been leveraged buyouts (LBO) and some have been financed by private equity (via cash and debt). I want to focus on the latter case, where private equity deals have been most prominent. One can argue tremendous liquidity in these vehicles with a vast reach of capital (some have said the total P/E dollars could buy up the entire stock market…but that’s far-fetched). I believe that new deals will start to dry up soon, and some deals may have trouble getting the needed financing due to woes in the credit market.
How does private equity work, moreso…how do they get these deals done at such large prices? Basically, P/E firms raise funds from investors and make deals using debt. The low cost of debt is preferred in an equity deal so long as the return on equity exceeds the cost of borrowing (financing costs). In many cases, P/E firms will run a firm for a certain period under their stewardship and then release the company onto the equity markets in IPO fashion. Often times the P/E firm will saddle the ‘new’ company with a great deal of debt as they cash out the new equity. It’s a game, of course….and timing is key.
What may put a halt to new deals? The credit markets are critical to the success of P/E firms, only the extent that credit products are available. The fluidity of the bond market allow these deals to get financed at good prices to the borrower. However, we’ve seen some tepidness recently, mostly caused by the subprime consternation. Bond buyers are becoming less likely to purchase debt, thus prices drop and yields rise…raising the cost of financing (hence, dropping the overall return on capital). We may see fewer new deals down the pipeline, especially if current deals have trouble closing. Could this start a market decline? Historically when P/E has been active the market has been closer to a top than a bottom. We’ll see if history proves correct.
Reality Check
Though we don’t randomly flip through every chart we can just because we can, we do have a few routine chart check-ups we do - if only to maintain our bigger-picture awareness. In one of those recent routine scans of sector performance, for some reason, the reality of the chart below just stuck with me. I wanted to share it today.
I know a lot of folks are thinking energy stocks have pretty much run their course and couldn’t possibly go any higher, right? Well, maybe. However, I also know a lot of people were saying the same thing about technology in late 1997….and 1998….and 1999 (and even part of early 2000). Yet, tech stocks were still raging right through all off that. Yes, they ultimately paid the price later, but some people made some big money by riding ‘overvalued’ stocks to record highs.
The chart below is a sector percentage change chart, rather than a traditional bar chart. The goal is to find relative strength or performance rather than plot absolute levels.The pink line, as you may guess, represents the technology sector. (The thin lines are the 200 day moving average of their respective sector percentage changes (though they don’t play a role here.) Care to guess which color is the energy sector’s percentage change? It’s the bright green one - a little thicker than the rest. It’s now the performance leader, going back to 1990.
The point, however, is to never assume anything is ever ‘too far’ or ‘too much’. It may seem crazy, but I don’t see why energy now couldn’t match technology’s wild run in the late 90’s. Remember, this is how it all started for tech back then. Maybe it will pan out, or maybe not. But right now, the energy sector has more relative strength than anything else.
We’ll look at this chart’s other sectors in more detail at a later time. I just wanted to get this thought out today.
Sector Percentage Changes - 1990 through present
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