The Fragility of the Private Equity Boom?

The Wall Street Journal today has two articles about the potential fragility of the buyout boom. The first deals with the problem of higher interest rates and the potential increase in the risk premium.

Sender, Henny and Serena Ng. 2007. “Market Pressures Test Resilience of Buyout Boom: Higher Interest Rates Raise Financing Costs; Signs of Fatigue Appear.” Wall Street Journal (8 June): p. A 1.

“With interest rates moving higher and the stock market suddenly hitting a losing streak, the private-equity firms that have been the driving force behind a historic merger boom now face a crucial test. Higher rates could drive up the costs of the heavy borrowing that big buyers have relied on to finance deals. Buyout firms and companies are planning to raise more than $250 billion via junk bonds and loans in the coming months to fund deals, according to data from Standard & Poor’s Leveraged Commentary & Data and Lehman Brothers. That is about enough money to buy all the stock outstanding of Wal-Mart Stores Inc. or Citigroup Inc. — two of the largest listed companies and most widely held stocks. At the same time, an inhospitable stock market could make it trickier for private-equity firms to cash out of investments they have already made.”

“Deals structured around the availability of cheap, easy money — including high-profile buyouts of Chrysler Group, student lender Sallie Mae and utility TXU Corp. — could suddenly turn more expensive than anticipated.”

“Many investors in recent years have poured ever more cash into buyout firms in search of outsized returns in a world of low yields. In turn, with bulging coffers, those firms have trolled the globe in search of acquisitions, borrowing at record low rates to pay for their targets.”

“Private-equity funds make acquisitions by borrowing large sums to purchase companies, whether public or private, hoping to sell them later at a profit. These acquisitions have been like rocket fuel for the stock market, as rich buyers bid up the shares for listed companies in an effort to take them private and other investors pile in, making bets on potential takeover plays. Many companies also have turned to mimicking buyout-fund tactics, borrowing money themselves and using it to repurchase their own shares or pay special dividends to shareholders.”

“More than $460 billion of debt related to buyouts done in the past five years is currently held by investors and banks around the world, according to data from Standard & Poor’s Leveraged Commentary & Data.”

“When the music stops, it won’t be a question of one chair short, but of many,” says Michael Ryan, a lawyer at Cleary, Gottlieb, Steen & Hamilton who leads that firm’s private-equity practice.

“Hedge funds are also playing an increasing role in pushing buyout shops to pay more for their prey. For example, in the case of Clear Channel, Fidelity was joined by Highfields Capital Management, a Boston hedge fund.”

“Pension funds, meanwhile, expect a stream of income from their private-equity investments and often recycle that money into new deals. But lately, the money going into new investments has been about three times greater than the money coming back from dividends, sales and new listings in this arena, says John Coyle, head of the financial-sponsors group at J.P. Morgan Chase.”

“The debt markets are a potentially bigger threat, though not clearly an immediate one. Investors have a huge appetite for corporate debt, in part because default rates are historically low, and are willing to accept relatively skimpy returns for it. In recent weeks, the additional interest that even the riskiest corporate bonds pay over Treasurys has fallen to a record low. This so-called spread, which is a proxy for investors’ appetite for risk, is currently around 2.5 percentage points, according to Merrill Lynch data. It was at 3 percentage points at the start of this year, while in 2002 it stood at more than 10 percentage points.”

“”For the last three to four years, every month every new deal seemingly has been more favorable” to the companies issuing debt in buyouts, says Jonathan Weiss, head of the financial-sponsors group at Wachovia. Not only have interest rates been low, he says, but buyout firms have been able to persuade many lenders to drop protections attached to their loans.”

“Many bankers say they won’t have a problem distributing the deluge of debt that is about to hit the market. “The market has shown a tremendous ability to absorb debt. Every time someone sets the bar of what may be too much, the deal gets done,” says Todd Kesselman, managing director of Precision Capital, an investment-advisory firm. He adds that most companies issuing debt to fund buyouts are large and well run, “and investors seem to find that combination attractive”.”

“Yields on long-term Treasury bonds have jumped half a percentage point in the past month, a significant move for such a short time frame. Analysts say the sharp rise in yields could make investors less willing to finance corporate-bond deals until the market stabilizes.”

“Even before the latest rise in Treasury yields, investors were showing glimpses of heightened sensitivity to what they were buying. One example was an effort by Tribune Co. to raise money through bank loans last month. It encountered significant resistance from investors who were doubtful of the company’s growth prospects in the weakening newspaper business.”

“Tribune ended up committing to higher interest rates on much of its debt and agreed to pay a chunk of it down much sooner than planned, potentially creating problems for itself down the road.”

“If investors are more antsy about lending large sums to weaker companies, that could prove a challenge for Chrysler’s impending fund raising. The ailing auto maker is expected to raise around $15 billion through new loans in the next month or two to fund its business under new owner Cerberus Capital Management, which is buying an 80.1% stake in the auto maker from Daimler.”

“”We’re concerned about the fact that many companies are now barely generating enough cash to cover their interest payments and have really little room for error,” says Geoffrey Gwin, principal of Group G Capital Partners, a New York credit hedge fund.”

“Real-estate loans show signs of softening in the wake of Blackstone’s $23 billion purchase of Equity Office Properties earlier this year. Today, bankers say, Blackstone couldn’t finance the mammoth deal on the attractive terms it received four months ago.”

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