The Beta of a LBO Fund in a time of crisis

Published: 23rd July 2009
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First, I remind that Beta represents the measure of risk of a company or a sector which we intend to analyse.

For its turn the financing of acquisitions by loan, commonly known as LBO (leverage buyout), is characterized by the fact that the investment funds get the shareholder control of a company through a loan of the bank entities, being that the payment of that loan is made by the company acquired, through its profits. The investment is risky once that the loan is large and it only becomes interesting for the private equity company if the expected return of the profits occurs in the short-term.

Naturally that, in situations of crisis, the resort to debt impacts mostly over the capital structure of the acquired company, once that the creditors and the shareholders have a greater risk of losses if the company decreases its activity, being that this greater risk is reflected in the capital structure through a higher prize collected over the capital invested in the company resulting, thus, in a higher capital cost.

Well, this fact results in the more company depends of financing through debt the higher the risk its ordinary shares will have and thus its Beta is higher.

So, it's not difficult to understand that the higher risk for operations originated by Private Equity Operators resorting to LBO is indexed to financial difficulties that can be caused by periods of economic recession and other complementary difficulties once they harm the accomplishment of calendar commitments of debt payments which can lead to technical bankruptcy or even definitive liquidations, implying thus, normally, the loss of investments to the respective private equity entity.

In fact, when these crisis situations happen the only solution is to low the fixed costs, i.e. the costs with employees and with structure (and also the expenses with research and development - R&D), maintaining or increasing, at the same time, the production through the efficiency of human resources' management and optimization of marketing operations.

However, in periods of crisis, the investee companies by the LBO Funds cannot continue reducing, for example, the production costs once that normally they had already done it to become profitable. With the impossibility of giving more guarantees to the creditor banks, the only solution will be, most of the times, its insolvency which naturally has a quite big impact in the Beta once it will end up incorporating the economic and financial risk associated to the effects of crisis.

Although the LBO operations are a generalized phenomena in Europe as it's demonstrated the fact that, only in 2007, the loans made by the bank entities to LBO Funds was over 140 thousand million euro, the fact is that, with the financial crisis, the banks turned off the tap to this kind of investments becoming, thus, an investment category unsafe to LBO Funds.

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