Friday Letter Debt not just a dirty word

Private equity groups are grappling with the issue of how to extend existing loans and source new ones in a macroeconomic environment that changes from week to week.

Debt may be a dirty word these days. But for private equity firms, it should be front and centre in their thinking this year.

First, there’s the small matter of about €70 billion of leveraged loans in Europe alone that will mature by 2015, according to Standard & Poor’s estimates. Much of that debt will begin to reach term from next year, meaning the need to refinance is growing ever more pressing.

Second, while it's widely recognised that value creation through operational improvement is the way forward in terms of driving returns, leverage remains a valuable tool.

But how much debt will be actually be needed to fund buyouts, with equity components on the rise? According to a recent survey from DLA Piper, 37 percent of respondents believed GPs would have to provide at least 50 percent of a deal’s enterprise value in equity. A year earlier, just 13 percent thought so.

Even that relatively high equity component leaves a substantial amount to be financed through debt or alternative instruments. Let’s assume that European buyout volumes this year match 2011’s total – €61 billion, according to CMBOR figures. Assuming a 50:50 debt-to-equity split for a similar number of transactions (possibly generous, since some smaller deals will be equity-only), that’s €30.5 billion of debt financing to source, on top of refinancing that existing €70 billion mentioned earlier. And that of course, is just in Europe.

But the macroeconomic environment – characterised at the moment by severe volatility, largely driven by the turmoil in the Eurozone – has prompted most traditional lenders to rein in issuance. As one senior executive at a large-cap private equity firm put it recently: “Banks’ risk appetite is changing from week to week. It’s a pretty unique situation.” Sources say traditional credit providers generally aren’t open to new issuances.

The solution? The brave, and patient, will cross their fingers and hope the markets sort themselves out in time to refinance loans before they reach maturity. Some canny GPs have already addressed the issue and have pushed maturities out through amend-and-extend deals or full-blown refinancings (in some cases with their own in-house financing arms).

But for many fund managers, the solution will be to cultivate existing banking relationships, in the hope that credit committees will sign off on strong credits, while simultaneously locating new sources of debt, in some cases off-shore. Resondents to DLA’s survey thought the majority of senior debt would be sourced from non-banking sources. Banks are set to provide 42 percent of senior debt, the survey said. The figure in last year’s survey was 70 percent.

This is good news for other debt providers, notably mezzanine houses and specialist debt funds, many of which have been raised by private equity firms or former buyout professionals for just such an eventuality. These alternatives can be a lot more flexible than traditional lenders; although since the costs are typically higher for sponsors, they won’t be the solution to all GPs’ funding needs.

Private equity has always prided itself on innovation, and this will be put to the test once again if credit markets continue to tighten. Just as we saw post-Lehman Brothers, in an uncertain, volatile environment, bold, creative and proactive fund managers will continue to be successful. But the prognosis for the rest may be grim.