US fills the debt gap?

Here’s an alarming thought, from Moody’s: the credit rating 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 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, adds Moody’s, it could be as many as half of them.

Many in private equity will undoubtedly point to the fact that similarly apocalyptic predictions were made in the aftermath of the financial crisis – and for the most part, the wave of defaults never really happened.

However, others in the industry believe that things really are different this time. For many European businesses, “amending and extending” is no longer a viable escape route in the same way as it was a couple of years ago, due to the limited availability of debt – a situation that is unlikely to change in the near future, given the ongoing chaos in the eurozone.

One of the big supply constraints for debt is a shortage of the collateralised loan obligations that becamesuch a big source of capital for leveraged buyouts in the boom years. At the same time, banks in Europe are being forced to reduce their lending activities as part of a general deleveraging process. During the next 18 months, Morgan Stanley expects European banks to to shrink their balance sheets by somewhere between $1.5 trillion and $2.5 trillion.

“All the banks are now under a lot of pressure to exit from the higherrisk credits one way or the other,” says Alex Griffith, a partner at law firm DLA Piper. “The question is, which way will they exit? Will it be through an aggressive default scenario – selling the assets to recover their debt – or will they be able to get the borrowers to refinance somehow?”

For some European private equity firms, one silver lining has been the emergence of alternative sources of financing – such as US banks. According to Standard & Poor’s Capital IQ LCD, European companies borrowed about €14.4 billion from US banks during the first five months of the year, more than double the €6.7 billion borrowed during the whole of 2011.

“There are a couple of sponsors I’m acting for who’ve got very good relationships with US-domiciled banks and they’re tapping into the liquidity in the US on a regular basis for European acquisitions,” says Griffith.

“For certain types of transactions, you need to find some or all of the debt elsewhere – and primarily in the US at the moment,” says Romain Cattet, a partner at Marlborough Partners. “We have developed our network among funds and banks in the US.”

Additionally, a substantial amount of liquidity is coming from US credit funds, a largely new phenomenon in Europe.

“Alongside the US lenders lending into Europe, we’re certainly seeing the trend of debt funds come into the market,” says Griffith. “I wouldn’t say they’ll completely fill the gap, but certainly they are a very well received additional resource for the sponsor community.”

It’s hard to imagine these resources taking the place of the banks altogether. But when the stakes are as high as this, for all concerned, don’t underestimate the industry’s ability to muddle through and find some sort of an accommodation with its lenders…