Loose covenants sink ships

21Feb07

The continued rise of the private equity industry has become a significant part of our coverage here at Abnormal Returns. Our interest was in how the behavior of private equity affects the larger capital markets. However we are mere PE dabblers in comparison to one of our favorites Going Private. We were heartened to see GP back online and producing two new interesting posts that help explain what the heck is going on out there.

First Going Private discusses the overlap of hedge fund activists and private equity and how the interplay between the two could mean a much longer life for the private equity boom than that discussed by the many naysayers.

The more interesting interplays exist in the > $7.5 billion market capitalization area, where the two genres have more interplay. Reading the literature it becomes apparent that some of the highest gains in activist strategies are those where divisions or, indeed, the entire firm is sold. Private equity buyers wait eagerly in the wings.

One of the driving forces behind the private equity boom is the continued availability of cheap debt financing at favorable terms. For instance, Henny Sender in the Wall Street Journal notes the rise of so-called “PIK toggle” securities that provide private equity borrowers some additional flexibility to defer interest payments in light of a cash flow crunch. This is also helping boost bid values.

The increased use of these bonds is one of the latest examples of the easy lending terms that dominate the corporate borrowing market these days and have helped fuel the historic buyout boom. It also is a sign the boom could keep going for some time.

Going Private has a nice review of the topic including this nugget,

Used prudently, PIK Toggles seem like a decent tool to hurdle a speed bump or two in the road. I suspect, however, they cause some rather severe damage to the rims of the faster driving deals out there.

Not only are innovations leading to increased private equity borrowing, so are lower rates and loosened covenants. DealBook pointed us to this piece by Harris Rubinot at Bloomberg.com on the continual move down in risk premiums required by leveraged lenders to buyout firms. Indeed the times are so good that firms are now able to refinance earlier loans at attractive rates and terms.

“This is the best loan market for borrowers I have ever seen,” said Kenneth Moore, a managing director at First Reserve Corp., a private equity firm in Greenwich, Connecticut, that manages more than $12.5 billion and specializes in buying energy companies.

At the very least, it is worthwhile noting the market conditions that are allowing private equity firms to continue borrowing more money for bigger deals. It is possible that we have reached some sort of stable equilibrium where borrowers and lenders can stay in sync at these low rates. At its worst this behavior represents a dangerous shift in risk-seeking behavior. In that regard, only time will tell.

*For additional coverage of the private equity industry, Fortune magazine has issued their “Private Equity Power List” and a series of follow-up articles.

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