Tuesday, April 10, 2007

Private Equity Feasting at an "All You Can Eat" Debt Buffet

News came in yesterday that private equity has so far raised more than $35 billion this year for buyout deals. That will make for a nice down-payment for a lot of big deals, which would lead to a lot of new debt. While many speculate on how legislators on the Hill will address the question of how to tax private equity profits, others are looking at where these firms get the money to make their deals. Specifically, what are the ramifications of buyouts that depend on high levels of debt?

Standard & Poors warns that the debt levels of European private-equity deals means there is a one in five chance that companies taken private using debt financing will go into default and CNBC’s David Farber recently reminded readers about the 1989 deal that nearly bankrupted its creditors. So why are financial institutions lining up to finance these deals with leveraged loans that require few, if any, covenants? (Remember, Blackstone's record-breaking $39 billion purchase of Equity Office Properties, for example, included $16 billion in debt.) Some suggest that the handsome fees investment banks earn for their advising services might be one answer. The fees to advisors in the Equity deal totaled $75 million, and Bloomberg calculates that banks stand to collect over $2 billion in fees for deals announced in the last few months alone. As Goldman Sachs CEO Lloyd Blankfein is reported to have said recently, if a company wants to be an advisor on these deals, "one of the consequences of that is we will have to do more financing in addition to the advice we give."

With the deals getting ever larger, feasting on cheap debt, we are left wondering who is going to have to pay the tab if private equity’s plans to create value in their portfolios don’t pan out. The availability of easy credit and the lowering of underwriting standards led to the current collapse in the subprime mortgage market, are we to see the same with private equity?

1 comment:

ilanit said...

A lot of time is spent on the alpha versus beta debate but little consideration is given to another equally important but often ignored greek letter - rho or the sensitivity to changes in interest rates. Some San Diego business investors fund strategies have negative rho, that is depend on interest rates staying low. Ironically pension funds have positive rho as rising rates permit them to use a higher number to discount future liabilities. That can be a pyrrhic victory because on the asset side of the balance sheet their portfolios of stocks and bonds tend to fall in such times. It therefore makes sense for investors to diversify with OTHER strategies that tend to perform well in a RISING interest rate environment.