The equity market is dull and M&A patchy but private equity is on fire. Barely a week goes by without a landmark deal. What is especially striking is the amounts private-equity houses have been able to pay for their targets. And that is a function of how much they have been able to borrow.
A consortium of private-equity houses has just paid e3.7 billion for French retail group Pinault-Printemps-Redoute's Rexel subsidiary, equivalent to 11 times its ebitda. Moreover, it funded the deal with debt equal to almost seven times the underlying earnings of the business. In another transaction, Apex and Cinven paid e2.1 billion for Dutch media company VNU's directories business, borrowing seven times its ebitda.
In the third quarter of 2004, 57% of big leveraged buy-out deals were financed on leverage multiples of five times or more, according to Standard & Poor's. Not since 1998 – when the near-collapse of hedge fund Long-Term Capital Management triggered a credit crunch – have so many deals been done on such high multiples.
Is this an ominous sign? The industry says it is not taking on too much debt. Firms point out that interest rates are much lower now than six years ago, so companies can support bigger debts. Average LBO ebitda now exceeds its interest payments by 2.6 times, according to S&P compared with 2.0 times in 1998.
But if companies are being loaded up with massive debt, that puts the equity of financial sponsors at risk if valuations fall. And the same applies to mezzanine debt positions if things turn really nasty. Suppose the economy turned down and Rexel's enterprise value fell to nine times ebitda. Then its buyers would have lost about half their investment, marked to-market. This is not just theoretical. In November, Candover wrote down 75% of the value of Ontex, a nappies business in which it invested in 2002.
So why are investors prepared to risk so much on buy-out deals? In part because the private-equity houses have raised huge sums in recent fund launches. They are now competing with each other for assets in which to invest. But the real reason is that banks are offering such generous lending terms.
Why are the banks feeling so generous? They tend to give two answers. One is that, with so many deals on offer, they can pick and choose the best ones. The other is that they are easily able to lay off their risk.
Is this convincing? Not entirely. Take the argument about selectivity, for instance. It may be that some banks are shrewd in their choice of credits. But not all recent deals seem suitable for massive gearing. Rexel, for instance, is a cyclical distribution business operating on a 5% margin.
The point about laying off risk is more complex. Typically, a buy-out firm funds one third of a purchase with its own equity and two-thirds with debt. The latter comes, initially, in the form of a bridge loan from a bank. But later the bank seeks to offload its exposure. It offers the riskiest slice to junk-bond investors and syndicates most of the remaining debt to other banks. This puts in a fat slab of subordinated capital underneath its own exposure.
Laying off risk has been easy in recent months. That's because hedge funds and in some cases banks have been seeking high-yielding investments to spice up returns. They have been piling in to leveraged loans and junk bonds, causing their credit spreads to narrow and their prices to rise.
But at some point they are likely to reassess the risk-reward balance in this trade. And the lower spreads go, and the more leverage that is put into the debt, the sooner that moment is likely to come.
Collapsing bridges
Now consider what will happen when investors lose their nerve. Suddenly, the arranger of a bridge loan will be unable to syndicate it. The unlucky bank will be saddled with billions in unwanted debt. And if it is really unlucky – if the borrower warns on profits, for example – its highly leveraged loan will plunge in value.
Why do banks even contemplate such risk? Maybe because they don't think they will be the ones to get caught. And because they are making hay out of this business while the sun shines. Buy-out firms are currently among the biggest providers of fees to the financial services industry. Kohlberg Kravis Roberts is thought to spend $750 million a year on fees, Blackstone more than $500 million and Permira nearly as much. With the rest of their businesses relatively quiet, many banks feel they can't afford to miss out on these.
Whether or not this is sensible, someone is likely to come a cropper at some stage. When they do, a lot of high-yield investors will suffer, as LBO risk will be repriced across the markets. Some banks are already getting twitchy. Danske Bank, for instance, recently retreated from LBO financing. This suggests it might not be long before somebody gets caught in the trap.