Modeling Leveraged Buyout Risk in Corporate Spreads: Industry Patterns in Buyout Activity

Abstract

The recent buyout wave, unprecedented in both number and value of transactions, motivates this study of the pricing of LBO risk in credit spreads. Based on empirical evidence on the effect of LBOs in debt markets, this paper proposes a learning-based model of corporate credit spreads that explicitly incorporates both default and LBO risk. We find increased industry-level clustering in buyout activity and postulate intra-industry reactions in debt markets as a driver of the evolution of LBO risk over time. In this model, investors revise their beliefs on LBO risk via a mechanism of Bayesian updating observing industry-level activity. Estimates of the time series of LBO risk and model spreads suggest the proposed mechanism is significant in explaining observed market spreads. Estimated LBO risk is also shown to explain some of the mispricing from a structural credit model. Interestingly, using this mispricing can improve prediction of LBO likelihood.