46 Pages Posted: 28 Dec 2009
Date Written: July 2009
Driven by the unprecedented levels of leveraged buyout activity in the years 2004-2007, this paper studies the pricing of LBO risk in the cross-section of corporate credit spreads. Using a dataset of LBOs, CDS and bonds, I first study the reaction of credit spreads of target firms to LBO announcements in the US during the years 2001-2007. I find evidence of credit spread widening by 60-70%, suggesting costs of additional debt significantly outweigh potential increase in expected cash flows. I document a negative reaction in prices of unprotected bonds, suggesting wealth transfer from debt-holders to shareholders. Yet, back-of-the-envelope calculation shows gains to shareholders are due, in large, to alternate sources, implying value creation in LBOs. I then proceed to test whether LBO restructuring risk is priced ex-ante by investors in debt markets. Using exogenous industry-level variables, I find that firms more likely to undergo an LBO have spreads that are higher by 30-50 bps. Incorporation of results into credit pricing models could further our understanding of the cross-sectional variation of credit spreads and alleviate model spread under-prediction in buyout boom years.
Keywords: credit spreads, credit default swaps, leveraged buyouts, private equity
JEL Classification: G12, G13, G14, G34, C23
Suggested Citation: Suggested Citation