Friday Letter Hitting the wall

One of the least surprising news stories to emerge this week was a report (from law firm RW Baird) suggesting that European M&A activity slumped to its lowest level for almost three years in April: August 2009 was the last month when there was such a dearth of deals. Inevitably, the report pinned the blame on the ongoing chaos in the eurozone, suggesting that the recent elections in Greece and France had "heightened uncertainties".  

However, the more serious headline this week, at least as far as European private equity is concerned, came from Moody's. The ratings agency reckons there are some 254 private equity backed companies in Europe with debt due to mature in the next two to three years, collectively owing €133 billion – and it thinks that at least a quarter of them are likely to default on their obligations. If economic conditions get worse and shut off the high yield bond market, it could be as many as half of them. That's a fairly alarming prospect, for the industry and the banking sector alike.

The question is: is it a realistic prospect?

At first glance the answer would appear to be no. After all, we've been here before: the onset of the financial crisis sparked all kinds of apocalyptic predictions about the huge number of defaults we were going to see by private equity backed companies. But it didn't happen – either because lenders agreed to 'amend and extend', or because sponsors pumped in more cash, or both. As a result, the much vaunted wall of maturity kept getting pushed back (becoming increasingly less wall-like). Indeed, Moody's points out that the quantum of debt due to mature in 2013 has come down substantially in the last few years, and has been reduced by 75 percent in the last 12 months — suggesting that firms have done a pretty good job of refinancing their most urgent loans. As long as they can continue to do so — and both sides clearly have an incentive to make that happen– that 25 percent figure may end up looking outlandish, just like some of those post-crisis predictions turned out to be.

However, it may not be that straightforward. One of the reasons banks were able to agree to amend and extend deals in the wake of the crisis was that most people thought we'd be well into the recovery by 2013; now, when there's still no real sign of light at the end of the tunnel (particularly in Europe), that kind of rationale is harder to justify. The European banks still have a huge amount of deleveraging to do; so far they've been able to keep kicking the can down the road, but presumably that can't go on forever.

In addition, given how hard many firms have been working to push out maturities, the concern must be that any companies who needed to refinance their 2013 loans and had the werewithal to do it would have done so by now; hence those that are left will probably contain a relatively high proportion of duds who have already tried and failed to alter their terms. In this scenario, a 25 percent default rate becomes much more plausible.

It's perfectly possible that the post-crisis day of reckoning that so many people predicted for private equity backed companies never went away; that it just got pushed back a few years instead. But when the stakes are as high as this, never underestimate the industry's ability to muddle through and find an accommodation with its lenders — by pumping in extra capital, or tapping the high-yield market, or making use of IPO windows to raise some extra capital.

What isn't in doubt is that sponsors and their debt providers are facing a huge challenge. But as far as that 25 percent figure goes: we'll believe it when we see it. (And either way, let's hope it's wrong.)