Rising volume of high-risk debt sparks concern for private equity

The volume of high-risk debt issued by European companies has risen sharply this year, sparking worries that private equity investors will face a high risk of default in the future.

The number of high-yield bonds issued in the European Union has risen from €19 billion in 2005 to an estimated €30 billion in 2006 as the benign economic conditions and liquid debt markets have allowed companies to fund themselves cheaply.

Close Brothers expects the debt markets to tighten in 2007 and 2008, which will lead to a growing percentage of the high yield bonds maturing in those years facing difficulty in refinancing.

Matthew Prest, a director at the Close Brothers special situations group, said: “Bondholders will look to recoup their losses and if that means debt-for-equity swaps then we’ll see a lot of companies changing ownership with follow on deal activity spurred by a wave of mergers and acquisitions.

“This will lead to an escalation in stressed and distressed situations.  Corporate restructurings will increase and with the increased layers of debt that now exist in many company capital structures, combined with cross-border legal issues, these situations will be highly complex.”

The issuance of low quality bonds, CCC-rated bonds, is on target to reach €3.3 billion this year from $2.2 billion in 2005.

As one third of CCC-rated bonds have historically defaulted after two years, with 44.7 percent defaulting after three years, Close Brothers predicts default rates will start to pick up naturally from 2007 to 2008.

Prest said: “Many struggling companies will not be able to continue refinancing their way out of trouble as has been the trend of recent years.

“The biggest impact is that we will see a number of deals, which have been done over the last couple of years, enter a more difficult stage when the owners of the businesses and the companies themselves will discuss with lenders to restructure the debt.  Of those deals, there are a number that have been done already where you see lenders giving companies breathing space and reducing interest rates but the more you go back to the lender, the less willing he is to make more changes.  Additionally, the debt trades so the people who held the debt when you started are different so you do not have a realtionship with them.”