Skewed Prices Will Have To Correct

The leverage buyout activity of 2014 has been getting a lot of attention over the past few days. If you haven't had the chance, I suggest reading the breakdown of the quality of the paper backing LBO activity this year on our CEO's Tumblr, it's is highly recommended.  The LBO market is explosive and the Wall Street Journal highlights this morning that the banks making the loans have been skirt federal guidelines regarding the size of the debt loads  in connection to the target firms loaded with debt that is no more than 6x it's EBITDA.  The lenders have had to be rebuked by the Federal Reserve and the Office of the Comptroller regarding their choices to extended loan repayment timelines and issuing loans that don't "contain lender protections know as covenants".

Further more, one of the serious hot spots in this area has become the Utilities and Energy sector where the combined LBO levels of the two sectors is approaching $16 billion.  In 2013 the utility and entire sector only saw $10 billion in LBOs, which puts 2014, on a linear extrapolation basis, on track to surpass the 2007 levels of LBO transaction sizes in 2014.  

Surely the past few years of cheap money have driven firms to choose profits over production, which is a cause for concern when addressing the strength of our "recovery" in the face of the Fed announcing their desire to stop buying US Treasury Bonds and Mortgage-Backed Securities.  Investors must be careful going forward when valuing firms and or sectors as the flood of cheap money has caused valuations to rise above credible levels.  For a closing thought regarding borrowed money causing excessive pricing levels of buyout targets, remember that our equity markets are experiencing something similar but in the form of retail-investor borrowing. 

Many participants are borrowing to drive up prices to mask the lack of production being utilized as the driving force behind valuations.  We've skewed the system and there's only way to adjust to accepting pricing levels, which is to experience a pricing correction.  Like all things, this momentum can not last forever and will end soon, perhaps once the FED ends it's ridiculously elongated policy of cheap and easy money.