Already, things are looking up in 2010. The high-yield markets are loosening and, overall, the credit markets are thawing. Many big banks are not, in fact, going under and are now looking to restore their capital bases.
Business as usual, right?
Unfortunately, no. Recent easing in credit markets and the indigestion caused by too many bad loans has encouraged the current trend of “amend and extend” or “kicking the can down the road.” Debt investors are giving many borrowers a reprieve and are increasingly willing to amend or extend rather than force a negative outcome, like a bankruptcy filing, conversion of debt to equity and more write-offs.
As a result, many in private equity have been given more time to wait out the current downturn instead of launching full restructurings now, at a time when profits and valuations are low. However, private equity sponsors need to understand that this is just a reprieve and unless this grace period is used wisely, new capital injections could be just good money following after bad.
Waiting it out may just be postponing an unfortunate outcome when the debt ultimately matures or performance continues to disappoint. There's no guarantee that the economy will have fully recovered when we arrive to the point on the road where “the can was kicked”. What if recovery includes a reset to lower levels moving forward for employment, housing starts, etc? Then, an “amend and extend” deal is not enough, if the operational issues haven't been fully addressed.
Private equity sponsors should be asking all the tough questions of their portfolio company managements: Are we the lowest cost producer? Is our pricing right? Do we have unprofitable business segments? Why? Have we optimised manufacturing capacity? Have we fully rationalised back-office operations? Have we fully integrated all acquisitions? Are we truly efficient and poised for future growth? Have we taken out all excess cost? Really?
Credit alone won’t ensure that PE portfolios will emerge strong, competitive and ready to deliver for PE sponsors and their LPs. By expanding profits, increasing cash flows and reducing debt in the hard times, your investments will be positioned to deliver exceptional returns when the economy fully recovers. This time is a gift. Use it wisely to create companies that can not only survive, but also thrive. Your LPs will thank you!
James Loughlin is a principal and managing director of Loughlin Meghji + Company