Friday Letter Cooling Off

Amid the recent furore about the tax treatment of private equity on both sides of the Atlantic, it has been easy to forget that the biggest threat to the industry’s continued health and prosperity probably does not come from politicians and trade unions.  

The tax and regulatory environment will always be a key part of the industry’s success. But the recent private equity boom has been primarily fuelled by the massive explosion of liquidity in the credit markets, with lenders competing furiously to finance buyout deals on terms that have become increasingly favourable to the borrowers. When this liquidity starts to dry up, it will become much harder to do deals and to generate the kind of returns enjoyed in recent years.

The industry has been on a pretty good run. KKR may not be a very representative example, but its filing this week ahead of its $1.25 billion flotation revealed just how lucrative the last few years have been – the buyout giant has returned almost $16 billion to investors since 2003, after a string of successful deals.

But the KKR filing also sounds a cautionary note. It devotes no fewer than 27 pages to the risks the firm faces as it prepares to go public, most notably: “Dependence on significant leverage in investments by our funds could adversely affect our ability to achieve attractive rates of return on those investments”.

And there are certainly signs that the credit markets are starting to slow down, even though big bold mega-deals are still being forged as we speak. In the US, four financing deals have reportedly been pulled or sweetened in recent weeks, including Dollar General and FoodService. Yesterday, Bloomberg reported that a number of large institutional lenders were starting to shy away from buying leveraged loans.

Ratings agency Standard & Poor’s LCD research division also seems to think so. It told PEO: “In recent weeks, account anxiety has spiked thanks to several factors, including the recent stock market volatility, weakness in the LCDX index and renewed worries that the sub-prime meltdown, in light of the implosion of two Bear Stearns hedge funds, might yet put a damper on the critical flow of CLO money, which has long fed loan demand.”

The consequences of this are already clear. Sponsors bringing new deals to market have less flexibility to dictate aggressive terms – for example the controversial covenant-lite loan structure, which was becoming increasingly commonplace in new deals, will probably be out of the question for the time being, bankers say. In the meantime, lenders are waiting whether this is just a temporary cooling-off period for a hot market – or the beginning of something more serious.

Jonathan Guise, managing director of leveraged debt specialist Blenheim Advisors, thinks recent developments have been no bad thing: “People are really holding their breath a little bit to see what will happen. But in general terms banks are taking the opportunity to have a real think about what they’re doing – it’s probably brought a bit of perspective back into the market.”

The shift back towards the lenders is partly driven by an increase in supply, thanks to the number of massive buyouts agreed recently. According to S&P LCD, there is a record $215 billion of institutional paper in the pipeline, compared to $120 to 140 billion earlier in the year.

However, this has not changed the underlying dynamic of the market, according to Guise. “It’s still an aggressive marketplace, notwithstanding the recent wobbles. There’s still much more demand than supply – there are a lot of new loans coming to the market, but there’s still an awful lot of institutional demand.”

LBO investors across the globe will be hoping that this is true – or spats with trade unions may be the least of their worries.