Leveraged Buyouts and Credit Spreads

Abstract

This paper studies the impact of LBO restructuring risk on corporate credit spreads. Using an extensive dataset of LBOs, CDSs and bonds, we first study the reaction of credit spreads of target firms to LBO announcements in the US during the years 2001-2015. We find that CDS spreads increase by almost 60% for investment grade bonds and we document a significant negative reaction in the prices of corporate bonds. We then proceed to show that LBO risk is priced ex-ante by investors in debt markets. Results of a panel regression imply that firms more likely to undergo an LBO have significantly higher spreads. Moreover, we show that intra-industry CDS spreads increase in response to an LBO announcement, consistent with investors updating the probability of future LBOs when an LBO occurs. Based on this empirical evidence, we propose an extended structural Merton (1974) model incorporating LBO risk to study the impact on credit spreads over time and across maturities. Model estimation implies an increase of 30-35 bps in credit spreads due to LBO risk in periods with high LBO activity. The average contribution of LBO risk to credit spreads is as high as 15 bps at a 10-year maturity.