Insight: This isn’t the end of leveraged buy outs

By Joe Swanson Published: December 17 2008 16:54 Last updated: December 17 2008 16:54 While the financial sector turbulence of the past 18 months appears to be abating, owners of the more than $250bn of European leveraged buy-outs (LBOs) are looking over their portfolios with increasing concern. Bearish pundits, expecting a deep European recession, are predicting covenant breaches in as many as 50 per cent of outstanding European LBOs, placing the ownership of these assets in jeopardy. In this climate, one would expect private equity firms to be in disarray with their own investors threatening to withdraw support following a crash in the trading value of their funds. Appearances, however, can be deceptive. It is true that many of the assets purchased in the LBO boom were purchased at such high prices that the equity in most of these transactions will almost certainly never be recouped under current capital structures. However, many sponsors are looking at how they can exploit the weakness in the financial sector to make right some of their losses by recapitalising their assets through a combination of new equity and debt write-off. The key factor underlying the recapitalisation of impaired LBOs is the imbalance of liquidity between lenders and private equity funds. Since the summer of 2007, a series of structural changes has left the leveraged loan market in tatters. Banks, under pressure from new government owners, wary private shareholders and ardent regulators have drastically reduced their appetite for risk. Managers of collateralised loan obligations, structured finance vehicles that purchase leveraged loans, have lost their funding sources and can’t participate in new transactions. And hedge funds have seen waves of redemptions limiting their ability to invest and forcing many into a defensive posture. With these three main pillars of the leveraged loan market in retreat, liquidity has evaporated and yields have more than doubled from pre-credit crunch levels. On the other hand, and in spite of stories about investor revolts, many private equity groups appear to be liquidity-rich. Unlike many hedge funds whose investors have periodic redemption rights, most private equity funds are structured as medium-term investment vehicles where investors typically have no rights of early withdrawal and must provide additional funds. Armed with this war chest, an increasing number of private equity groups began buying debt in portfolio companies earlier this year – to position themselves for a future restructuring or to improve their financial return. As credit markets continue to deteriorate, many private equity groups are taking a fresh look at their portfolio companies with an eye to restoring value to their equity. Not content with opportunistically purchasing debt, sponsors are increasingly looking to enter into comprehensive restructuring negotiations with creditors. While the rules of the game are still being written, the general approach being taken is to base the restructuring around the enterprise value that could be obtained by selling the company in the open market. Once this price is agreed, the equity holders propose that lenders write off all debt above the “fair-market” value of the company in exchange for an injection of equity used to stabilise the business and fund operations. As with all trends, however, some groups will take things too far. Most successful restructurings of this type have shared one key point in common – the company being restructured had a liquidity crisis. To the extent creditors are not willing to provide “rescue funding”, the dynamic will certainly play to the favour of equity holders. Trying to force lenders to accept a discount where the company has healthy operating cash flows or where lenders are prepared to provide financing is not a dynamic likely to lead to peaceful resolution. In such situations, sponsors must decide whether the opportunity is worth tarnishing their reputation if some of the lender group refuse to welcome the “rescuer”. While the concept of “relationship” is being sorely tested in today’s market, there is likely to be a strong backlash if private equity firms are viewed as unfairly capitalising on the weakness of their lending partners. The writer is co-head of European restructuring at Houlihan Lokey, an international investment bank