Global credit markets continue to suffer upheaval, but it might not be all bad news for private equity, according to two recent reports.
Goldman Sachs believes falling asset prices could help the industry keep spending the vast sums of money it has accumulated in the last year, while ratings agency Standard and Poor’s has argued the current problems could actually prove to be a welcome correction in the debt markets.
S&P’s report took a largely optimistic view of the current credit difficulties, suggesting they will bring an end to “classic top-of the market” structures like cov-lite loans and PIK notes, and predicting that even in a worst case scenario banks will be well placed to adjust to revenue losses.
The S&P report “Leveraged Finance Market Jitters Highlight Risks to Banks” acknowledges that current jitters in the credit markets could be the beginning of a more severe downturn, but it argues that fundamentals remain strong.
It said: “Activity will remain soft at least through the summer, but remain underpinned by the generally supportive economic outlook. We expect a moderate increase in corporate defaults from the current cyclical low, but a harder landing cannot be ruled out. Heightened risk sensitivity among investors also raises the possibility of further falls in prices and liquidity.”
The key problem for the buyout industry is the negative impact on returns, according to S&P: “It seems certain that the LBO market’s glory days are over and the future environment will be more challenging for sponsors and banks alike.” While sponsors have huge amounts of unspent funds, their internal rates of return will be pressured by the higher cost of capital and the need to provide greater amounts of equity to new transactions, it added.
On the plus side, Goldman Sachs has argued in its latest report entitled “Strategy Expresso: Credit Congestion” that the wall of money that flowed into private equity sector is likely to continue to support activity – and there could be a positive effect on pricing. Goldman said: “While funding costs and leverage ratios are likely to move adversely, the cost of targets is also likely to fall.”
But what of the banks? So far, current underwriting commitments have not compelled S&P to change any of the banks’ credit ratings. After stress-testing the market to take into account what it terms “a severe downturn”, characterised by falls in prices and liquidity, it concluded: “Our analysis shows that this would certainly be a painful scenario, but banks should be able to absorb the effects at their current rating levels.” However, a widespread deterioration across the credit markets could impact individual ratings, it admitted.
Both reports agreed that because of the large underwriting pipeline when the market turned, this will contribute to mark-to-market losses in third-quarter earnings. Estimates for the extent of the worldwide pipeline of unsyndicated debt currently vary from $250-350 billion. Earnings losses, caused by the inability to syndicate the debt, will be exacerbated for those banks that have employed aggressive structures such as cov-lites and PIKs, S&P said.
S&P said: “A severe but plausible stress would be a 50 percent decline in leveraged finance revenues, which is similar to the fall already seen in US sub-prime RMBS origination.” S&P predicts the worst affected bank in these circumstances would be Credit Suisse, which underwrote $2.1 billion in 2006, a 50 percent increase on 2005. However, it predicts that even for Credit Suisse this would lead to a 3.8 percent fall in group revenues. Although this would be a significant loss, S&P said it does not indicate that banks are dependent on the LBO market.
Richard Barnes, a director at S&P and the author of the report, said: “The worst case scenario is that to clear existing pipeline, banks have to take material mark downs on the positions that they are holding.”
But the starting point for banks is very strong and they are capable of managing significant deterioration, he added. “The sponsors and banks have a shared interest in making sure pipeline gets placed. They may work with the banks to add a covenant change and other terms to get everyone happy with the deal.”
In the case of the failed syndication of the Alliance Boots debt package, for example, Barnes said the underwriting banks could have placed the debt, but decided they could get a better price by holding off. He cited sources close to the deal.
Ian Hazelton, chief executive of debt investor Babson Capital Europe, is also optimistic about the longer term: “We’ve not been here before and this isn’t similar to other tops of the market. It is a private equity owned universe which likes to operate with leverage.” According to Hazelton, despite the current low profile of institutional players in the debt market, they are here to stay – meaning there will be availability of leverage even if banks scale down their underwriting commitments.