A silver lining?

Recent statistics don't make great reading. Standard & Poor's market figures to the end of September reflect a peak in rolling 12-month EU speculative grade default rates at 12.68 per cent. As for wider measures, the rating agency also reported recently that the number of issuers currently facing relegation to the dreaded CCC category (the lowest level absent actual default, and a sure-fire sign of significant difficulties facing the issuer) had increased over the past year and that the number of issuers rated B- (the level closest to the CCC category) now constituted 3.4 per cent of the rated universe of credits ?more than those rated AAA account for. And if that wasn't enough, there was an article in the Financial Times recently asserting that the global value of bond defaults for the year to date had surpassed $140bn, beating last year's sad record of $135bn.

New issue markets too have been fickle in terms of what they considered acceptable risk, with many European capital markets professionals ending up with egg on their faces. Although some transactions have been completed successfully over the past two quarters, recent private equity backed deals have made a largely negative impact. Jefferson Smurfit, the supposed bellwether financing, couldn't raise even half of its Euro bond deal and then performed comparatively poorly in secondary trading. Brake Brothers was forced ultimately to pull its deal entirely. And, in an unprecedented demonstration of exactly how not to market an issue in a difficult market, Gerresheimer was pulled not just once, but twice after the lead managers, Goldman Sachs and JP Morgan, appeared to send mixed messages to their accounts, thus almost certainly sentencing it to permanent deal oblivion.

So, if even the dealers can't call the market, surely those in search of capital, the deal sponsors, don't stand much of a chance to get it right either. Or do they? As is often the case, things may not be quite as bad as they seem.

For behind the default rate headlines lies in fact a more optimistic picture. Default rates in the US, according to S&P's figures, seem to have peaked and have now been consistently in decline since April. Europe usually lags, and if it follows the same pattern this time around, European default rates here can reasonably be expected to be on the decline by early next year. Encouraging noise has also come from Moody's recently, which said that their ratio of ratings downgrades to upgrades, viewed as an important indicator of credit trends, had fallen between the second and third quarters for both the US and Europe.

Furthermore, much of the really bad news is confined to the media sector, where private equity plays a less significant role. In fact, of the major defaults of publicly rated issuers in Europe so far this year, only Equitable Life, which is a rather different story anyway, and IFCO Systems, a listed company, though controlled by German family shareholders, were non-media credits.

Fitch, in its recent review of leveraged finance activity for the first half of 2002, reported that of 234 ratings issued over the past three years (the majority of which were in relation to leveraged loans destined for CDO portfolios), eleven suffered ?some kind of distress situation? and only two loans suffered an actual payment default, one of which was believed to have resulted in a 100 per cent recovery to lenders.

Certainly, since the end of the summer, the LBO loan market has been in overdrive following the launch of the two biggest European transactions ever, for Legrand and Jefferson Smurfit respectively (though at the time of going to press, the former deal was threatened by a reversal of the competition authority's decision which prompted it in the first place). And then there is the ever more ebullient mezzanine houses apparently ready to step in for the hapless high yield market. Granted, the renewed uncertainty hanging over the US economy and the prospect of war in the Middle East certainly put a dampener on investment prospects. But should there really be no grounds for optimism? Private equity professionals often tend to be at their best in adverse market conditions. Their job is to find opportunity amongst all the peripheral noise, and with such a lot of noise at the moment, who says that there isn't plenty of opportunity?