The effort to take Dell private has received a fair amount of attention, in part because it is the first big leveraged buy-out in years.
There is reason to believe that the deal could be a harbinger of things to come, although the conditions that make big buy-outs attractive may not persist for much longer.
The question for analysts is whether the current spread between the cost of equity and the cost of dubious debt is sustainable.
You might think that corporate debt should yield less than shares because debt has a higher place in the capital structure than common stock.
However, equity owners have a claim on the bulk of any growth in profits over the lifetime of the company. This claim is generally worth more than enough to offset the junior status of equity holders in the event of bankruptcy, especially for firms that are not already on the brink of collapse.
As a result, the earnings yield for a firm’s shares is usually lower than the yield on its bonds. In America, the yields on stocks have generally been below yields on corporate debt since the mid-1960s.
Since the crisis, however, the pattern has reversed itself. Irrespective of whether you prefer using Robert Schiller’s cyclically-adjusted earnings yield or the more common one-year trailing earnings yield, stocks now yield either the same as Baa corporate bonds or slightly more.
Perhaps even more striking is the collapse in the spread between junk bond yields and the yields on stocks issued by America’s most valuable firms.
This suggests the possibility of an arbitrage: borrow money at a rate comparable to the junk bond yield and use it to buy public companies.
That, of course, is a key ingredient in the private equity business model.
As long as the target’s earnings grow over time and there are no problems with debt refinancing, this should generate a nice return. We may see more big leveraged buy-outs if this unusual spread persists.
Source: THE ECONOMIST – Free Exchange Economics