THE BOOTS ON THE OTHER FOOT

What, from an investor's point of view, is private equity's most appealing quality?

There is of course no right answer to this question, but one big attraction of private equity is its built-in optionality. Within the terms of their stated investment strategies, which are more or less loosely defined in their limited partnership agreements, managers of private equity funds are at liberty to go about their business in whichever way they think most productive.

To make a portfolio company more valuable, GPs can choose from a catalogue of strategic, financial and managerial measures. To realise a return, many routes to exit are available. And when it comes to selecting assets for acquisition, optionality is their friend once again.

This is helpful, especially in times when markets are jittery. It allows private equity funds to go where others fear to tread and take advantage of opportunities that market participants whose mandates are less flexible are unable to exploit.

The current dynamic in the leveraged loan market illustrates this perfectly. Ironic as it may seem, it is no surprise at all to see private equity firms first in line to buy up the debt the arranging banks are still so desperate to shift. Clamouring for balance sheet relief, the lenders are offering the loans at discounts – 91 pence in the pound for instance in the case of Alliance Boots, the UK chemist sold last year to Kohlberg Kravis Roberts in Europe's largest LBO to date.

At press time, a number of brand-name buyout groups, including a fund advised by KKR itself, were on standby to purchase big chunks of the company's £9 billion of debt. And in addition to offering the loans cheaply, the banks were also putting in place generous helpings of fresh leverage – 80 percent debt alongside 20 percent private equity money to get the deal away.

It goes without saying that for the private equity groups, this kind of opportunity ticks all the boxes. First of all, it gives them something to work on that is big, fundable and deliverable – still a relatively rare find in today's environment. It also promises an attractive return on equity.

Furthermore, it provides sponsors with a chance to give their clients access to something many of them are very keen on: loans that for one reason or another can be purchased at low prices. (Confirmation that distressed debt really is flavour of the month came recently when Oaktree Capital Management, the Los Angeles-based alternative investment specialist, closed its latest distressed debt pool at $10.9 billion – more than three times the size of its predecessor fund.)

And who knows? Private equity riding to the rescue of the problemstricken banks might even result in some positive publicity.

The risk, especially in a recession, is that Boots and other credits being subjected to this treatment may end up in default. Here, comfort comes from the fact that the loans in question have notoriously light covenants. And if the equity at risk is a worry to the sponsors, just think how badly the banks, which are in effect “doubling down”, must be dreading the possibility of getting caught with the same companies for a second time.

As Guy Hands, the founder of London-based LBO powerhouse Terra Firma argued at a recent seminar held by SJ Berwin, the law firm, there is technically and legally nothing wrong with the way out of the LBO mess that the banks now favour; but imagine, he warned, the barrage of criticism that will hit both lenders and regulators if “doubling down” winds up producing nothing but another round of write-downs. Not a pretty picture.

It may of course not come to this. If in fact these deals work out, the banks will breathe a much-needed sigh of relief. More importantly from a private equity perspective, success would bring confirmation yet again that the industry has an enviable ability to react to changing market conditions in ways that many of its rivals cannot. Optionality is always an asset, and in troubled times, it comes at a premium. Private equity has lots of it, and provided GPs use it well, every penny of the management fee is worth paying.