Leveraged buyout booms and busts: can Islamic finance help prevent and mitigate such market distortions?

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The industry of private equity and leveraged buyout has been, since its beginnings, subject to several chapters of bubbles and busts, the majority of whom are initiated under similar circumstances (excess of liquidity, junk debt and mimetic behavior).
The Islamic finance is a financial system that complies with the rules of the Sharia Law, and which naturally allows the achievements of purposes of Sharia, such as protection of property and capital, fair wealth distribution, reduction of uncertainty and speculation, to name a few.
From this perspective, this paper discusses the capacity of Islamic finance to help prevent some factors that trigger financial crises in the leveraged buyout market and to accomplish the intended purposes through this asset class.
In the first part of this paper, the authors try to break down some of these common factors that trigger or catalyze the economic booms of the leverage buyout industry, and propose a framework to visualize their effects through an agent-based Simulation program. The second part of the paper describes how Islamic economic principles constitute brakes to some distortions and excesses in the market, in such a way that the probability of occurrence of a boom decreases drastically. Finally, these Islamic features are added up to the simulation to provide a comprehensive benchmark.

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    • Figure 1. A simple illustration of an LBO deal structure
    • Figure 2. Value of leveraged buyouts in the US in $ billions
    • Figure 3. Debt to Ebitda ratios for leveraged buyouts in the US
    • Figure 4. Flow chart of the main program ’Go’
    • Figure 5. Flow chart of the bidding function
    • Figure 6. Flow chart of the auction function
    • Figure 7. Flow chart of the aging function
    • Figure 8. Market ebitda multiple evolution in a conventional LBO market
    • Figure 9. Evolution of Leverage ratio (Debt/Enterprise value) in conventional LBO market
    • Figure 10. Evolution of average companies’ equity in a conventional LBO market
    • Figure 11. Lorentz curve of companies’ equity after 40 periods in a conventional LBO market
    • Figure 12. Evolution of the number of bankruptcies in a conventional LBO market (out of 500 companies)
    • Figure 13. Market Ebitda multiple evolution in an Islamic LBO market
    • Figure 14. Evolution of Leverage ratio (Debt/Enterprise value) in Islamic LBO market
    • Figure 15. Evolution of average companies’ equity in Islamic LBO market
    • Figure 16. Lorentz curve of companies’ equity after 40 periods in Islamic LBO market
    • Figure 17. Evolution of the number of bankruptcies in Islamic LBO market (out of 500 companies)
    • Table 1. Model assumptions [conventional market case]
    • Table 2. Model assumptions [Islamic market case]