Friday Letter Good dislocation or bad dislocation

These are uncertain times for the eurozone. And what does this mean for private equity?  

Can the single currency survive in its current form? Are we on the cusp of a banking crisis potentially even more serious than the last one? Will economic stagnation be the norm for the foreseeable future?

Few in the industry would claim to have a definitive answer to any of these questions. But there is a school of thought that the current situation could work in private equity's favour. At PEI's recent roundtable on the sovereign debt crisis, Pantheon's Helen Steers argued forcibly that economic stability and growth is not a prerequisite for good returns: “Private equity always does well in a period of uncertainty and dislocation, because it creates opportunities. The worst possible thing for this industry is steady-state; you want change and dislocation because that creates the opportunities.”

It's true that in the past, private equity has been able to turn uncertainty and volatility to its advantage. When deals are complex, pricing is difficult and transparency is limited, the odds certainly favour sophisticated professional dealmakers. When fear and loathing is the order of the day, cool-headed investors have a good chance of picking up a bargain.

But will the same be true this time around? Dislocation is one thing; dislocation coupled with a burgeoning banking crisis is something else entirely. Europe's banks, already under pressure to reduce their leverage levels in the interests of greater financial stability, are now worrying about the possibility of a sovereign default in the eurozone – which could leave many of them facing huge losses. So it's no wonder many are already starting to pull in their horns on the lending side. William Allen, founder of Marlborough Partners, put it at our roundtable: “The banks are nervous as hell, and they're already starting to hoard liquidity.”

This is not just about financing new deals. It's also about refinancing old ones. Ratings agency Fitch estimated earlier this month that there were €200 billion of leveraged loans due to mature between now and 2014. If you work on the basis that Fitch probably covers about half the market and thus the true amount is probably closer to €400 billion, it's clear that the industry faces a huge challenge. Refinancing all this debt will be very difficult at a time when the banks are under so much pressure. “I think we’ve got two or three years of problems when it comes to bank liquidity, and it's going to hit the private equity industry generally when the refinancing wave comes around,” says Allen.

This doesn't necessarily have to be a mortal blow to private equity. The banks may be persuaded to extend their loans – if only for want of a better option. Firms may choose to ramp up the equity portion of their deals, and refinance when the debt markets pick up (although this will inevitably affect returns). Others may emerge to fill the liquidity gap – mezzanine funds, for example. And, of course, bargains could be had by investors savvy enough to enter the distressed capital structures of overleveraged or struggling European companies.

But the fact remains that banks are by far private equity's biggest source of financing. So the fortunes of the two are surely intrinsically linked; if the banks are brought low by the sovereign debt crisis, private equity funds will face some difficult challenges.

Whatever the next chapter in global capitalism's story, for private equity practitioners in the region, this is a time to be on full alert. Whatever happens next, it is going to be interesting.

Private Equity International examines these issues in detail in our forthcoming September issue, which includes a special roundtable featuring five industry experts who discuss the potential fall-out from the eurozone crisis.