The Side Letter: Why this isn't 2007

Toby Mitchenall 180

Toby Mitchenall

“I spoke to a banking lawyer who was trying to get the repayment covenant removed from the loan documents he's working on.”

So joked one credit investor at a working lunch in February. Some chortling followed, but was it nervous laughter? Covenant-lite or covenant-loose loans accounted for more than 80 percent of the European unitranche market in 2016, up from 40 percent in 2015, according to ratings agency Fitch

 As noted by our sister publication Private Debt Investor, this is alarming for those who associate covenant-lite with the pre-crisis days.

References to the excesses of the pre-crisis era are proliferating. “An overheated market intoxicated by cheap credit serves as a warning to investors,” cautioned an editorial in the Financial Times in February. News that Blackstone founder Steve Schwarzman's 70th birthday bash was scarcely less opulent than his infamous 60th in 2007 was too much for some commentators to ignore: surely it is a signal we have returned to the dangerous pre-crisis market peak.

Certainly there are some key metrics that suggest we should be concerned. Average entry valuations paid by private equity firms in the US hit 10.9x earnings last year, according to S&P Capital IQ. In 2007 the figure was 9.7x. Leverage ratios across the US and Europe in 2016 remained a little way off their 2007 peak, but as mentioned the terms on the debt are loosening. At the same time, GPs have been raising capital hand-over-fist and the industry seems to be dipping its toe into the unknown with the increasingly widespread use of fund-level leverage.

But let's take a breath and consider two good reasons why this is not 2007.

First is total deal value. In 2007 the total value of global buyout activity was $683 billion, a shade lower than 2006's $685 billion. Last year the equivalent figure was just $257 billion and the annual total has not exceeded $300 billion in any year since the crisis.

Driving these dizzying pre-crisis deal figures was a wave of ambitious public-to-private transactions. “In the London office we had the FTSE 50 up on a board,” remembers one strategy consultant. “We were pretty much ticking them off as sponsors called us up to say, 'A bank has offered us finance to take this company private, but we don't know it terribly well.'”

Banks were driving the transactions, says the same consultant; “nothing like that is happening now”.

Comfort can also be drawn from the absence of club deals. Some industry watchers – us included – have noted a recent increase in the number of deals involving more than one private equity firm, a common feature of the 2007 deal landscape. However, while it is technically true that the number of club deals is on the rise – data provider Dealogic counted 91 in 2016 – the total is still around a third of the 2007 total of 269.

There are other differences to note. Some high-profile episodes during the financial crisis stemmed from limited partners' over-commitment strategies. Listed fund investors, in particular, had made optimistic assumptions about future distributions covering future capital calls. A look across the listed private equity sector today shows that cash positions are more conservative. Some listed LPs, such as HgCapital Trust, even have the option to sit out a new investment without penalty should it not have the cash to invest.

The finance community has a reputation for having a short memory. We see evidence that private equity has not forgotten some lessons from the crisis.