Tuesday, December 17, 2013

Risk Appetite: Eating Well or Sleeping Well

Ralph and enjoyed teaching the December 4-6 Acquisition Finance Course at the Amsterdam Institute of Finance-despite enduring the worst storm in over 60 years while in Amsterdam. The attendees raised some interesting questions, which I will attempt to address in this and upcoming posts.

Readers of MergerProf will note one of the reoccurring themes is how changes in investor risk appetite trigger changes in buyout volume, capital structure, financing instruments and structuring. The attendees inquired about what causes risk appetite changes. This is an important issue for trying to understand markets.

Risk appetite is based on Keynes’ notion of Animal Spirits and included in behavioral finace. My understanding of risk appetite is as follows:

1)   Risk Appetite is driven by changes in investor wealth. When wealth increases it encourage investors to risk their winnings on more adventurous activities. When wealth decreases, in a downturn or market crash, it make us more cautious. This is especially true when the wealth decreases are large enough to cause solvency and liquidity problems which breach our budget constraints.

2)   Risk appetite changes, both up and down, are amplified by leverage and liquidity. Leverage allows us to invest more thereby lifting asset prices and collateral values. This creates a virtuous circle or positive feedback loop. As we all know, when this reverses, the downward price movement can be unpleasant.

3)   Liquidity is driven by rising asset prices and increased credit. It tends to be ephemeral and is never there when you need it as investors learned during the credit crisis. Hence the need to hold negative return assets like cash and treasuries as an insurance policy.

4)   Liquidity shifts as asset correlations change. All asset correlations, except for cash and treasury insurance policy assets, go to one in a crisis. Diversification evaporates just when you need it the most. As prices decline, we tend to liquidate our most liquid assets first, to make margin calls, to minimize capital losses. This triggers a vicious circle further reducing prices, credit and liquidity.

Currently, central bank Quantitative Easing efforts with their massive liquidity injections and falling yields have spurred investor risk appetite-more so in the United States than Europe given the improved domestic economy. Thus, U.S. buyout volume is strong, fueled by investor demand for higher yielding high risk instruments like “CCC” rated debt, high yield bonds, second lien loans, and covenant lite loans used to fund more aggressive higher priced buyouts. Interestingly, we are also seeing more PE sponsored IPO exits like Blackstone’s Hilton Offering. This is a reflection of an exuberant stock market compared to a more subdued M&A-trade sale exit.

We all know how this will end. We just do not know when it will end. We need to structure transactions able to withstand abrupt market changes. Of course, this comes at a cost.


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