PE Panorama – Old habits die hard

16 June 2014   Category: News, Asia, Global   By Paul Mackintosh

A new report from Reuters might give some cause for concern about the direction that global private equity (PE) is taking as the global sovereign debt crisis recedes. It indicates that banks and their buyout fund clients are reverting to their old dependence on leverage financing to drive deals, goose returns and bring in fees. Indeed, the report quotes Thomson Reuters and Freeman Consulting figures to the effect that banks have earned almost US$5 billion so far in 2014 from fees on junk bond issuance underpinning leverage loans. This just a month after Credit Suisse, Goldman Sachs and Morgan Stanley denied a $725 million buyout loan for KKR – surely anyone's idea of a blue-chip buyout borrower – when one of its portfolio companies tried to buy out a rival, amid concerns that US regulators the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp would disallow the transaction.

In a sign of the times, Jefferies Group, not subject to the same regulators, stepped up to lead financing for the deal. With the recovery in US GDP and stock market performance, institutions do not seem to have quite so much excuse to struggle for any source of yield, but the Reuters report indicates that banks and other finance houses are still trying to find ways to source leverage capital in the teeth of regulatory constraints all the same.

This may smack of systemic risk, but the real concern over the resurgence in leverage from a buyout perspective is that it is returning private equity to a habit it had seemed to kick, or at least get under control, as a result of the global financial crisis. Leverage certainly works very well to enable buyout transactions, but it was also the basis for some of the most sceptical assessments of the private equity industry prior to 2008. The sceptics charged that any parcel of listed stocks, leveraged up to the same level, would deliver similar returns to buyout portfolio assets, and their sums did look persuasive.

The more that general partners’ focused on recaps, covenant-late loan packages and financial engineering, the less they were focused on asset improvement, value enhancement, and company restructuring, and the more and more their claims to be responsible owners with great operational capabilities rang hollow. One kind of buyout investment does not necessarily have to be more socially beneficial or fundamentally attractive than another, but if there is any such differentiation, then the leverage-dependent kind did not look like the more appealing one. But it may be the one we are getting back.