Leveraged Loans 2007

Andre F. Perold; Erik   Stafford

Case | HBS Case Collection | April 2008 (Revised December 2008)

Leveraged Loans 2007

Abstract

The leveraged loan market was in a crisis during the summer of 2007, following many years of low realized volatility (less than 4% per annum), an index of leveraged loans had fallen over 5% in the month of July. A sudden drop in capital market prices for an asset class can be caused by news affecting fundamental values; or by a widespread liquidity shock. The implication of a shock to fundamental value is that the price drop is permanent, whereas if the underlying cause of the price drop is caused by a liquidity event, the situation may represent a profitable investment opportunity. Investors must assess the likely cause of the recent price drops in the leveraged loan market and determine an appropriate investment strategy.

Keywords: History; Financial Liquidity; Investment; Financial Crisis; Market Transactions; Disruption; Decision Choices and Conditions; Competitive Strategy; Capital Markets; Crisis Management; Commercial Banking; Banking Industry; Financial Services Industry;

Format: Print

7 pages

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Citation:

Perold, Andre F., and Erik Stafford. "Leveraged Loans 2007." Harvard Business School Case 208-145, April 2008. (Revised December 2008.)

We decompose bank activities into passive and active components and evaluate the performance of the active components of the bank business model by controlling for passive maturity transformation strategies that can be executed in the capital market. Over the period 1960–2016, we find that (1) unlevered bank assets underperform passive portfolios of maturity-matched U.S. Treasury bonds; (2) the cost of bank deposits exceeds the cost of bank debt; (3) bank equities have CAPM betas near one, while passive maturity transformation strategies have CAPM betas near zero; and (4) portfolios of bank equities consistently underperform portfolios designed to passively mimic their economic exposures. The very strong investment performance of passive maturity transformation strategies over this period may mask the underperformance of the specialized bank activities.

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Private equity funds tend to select relatively small firms with low EBITDA multiples. Publicly traded equities with these characteristics have high risk-adjusted returns after controlling for common factors typically associated with value stocks. Hold-to-maturity accounting of portfolio net asset value eliminates the majority of measured risk. A passive portfolio of small, low EBITDA multiple stocks with modest amounts of leverage and hold-to-maturity accounting of net asset value produces an unconditional return distribution that is highly consistent with that of the pre-fee aggregate private equity index. The passive replicating strategy represents an economically large improvement in risk- and liquidity-adjusted returns over direct allocations to private equity funds, which charge average fees of 6% per year.

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Leveraged Loans 2007

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