The Super Return conference draws its name and much of its mythology from happier times in the world of private equity. In previous years partners in the largest American buy-out firms are said to have raced their private jets across the Atlantic. At this year’s conference in Berlin there were few signs of such extravagance-just one lonely Bentley was parked out front. Unlike the years in which the assembled buy-out barons crowed about their mind-boggling profits, this year they were warning that few should expect any return at all.
Yet a more ominous pall hangs over the industry, and the firms they have bought, than the prospect of investors losing some of their money. A large number of companies it bought in recent years look as if they are about to go to the wall.
Many will fail for the obvious reasons; too much was paid for them amid rosy forecasts as to how much debt they could carry. Heino Meerkatt of the Boston Consulting Group reckons that as many as half of the companies owned by private-equity firms may default on their debt within the next three years, leading to a wave of insolvencies, and losses of as much as $300 billion washing through the financial system (some $50 billion-80 billion of which may be borne by the banks).
Yet it is not necessarily the most indebted companies, or those bought at the height of the boom, that will go bust first. The most leveraged basket cases are often left to limp along, mainly because they are worth so little that banks do not expect to recover much from liquidating them. And deals financed when bubble mentality was at its most frenzied often had so-called “covenant-light” loan agreements, which gave their bankers few rights to demand repayment. Many of these companies may go bust in time, but until then they too can keep drawing breath.
Worryingly, however, a large number of profitable companies that are still paying down their loans may go bust through no fault of their own. Simon Walker of the BVCA, an industry group, frets that British banks in particular are forcing sound firms into early liquidation over minor breaches of their loan agreements in order to reduce the size of their loan books.
In many cases banks may simply be reacting swiftly when companies trigger genuine tripwires, such as a fall in profit to below a specified level, which are designed to alert them to the possibility of trouble ahead. But the worry is that some banks, keen to rein in borrowing, are pouncing on purely technical breaches of banking covenants that have little to do with the underlying creditworthiness of the companies they have lent money to.
Gallingly, many firms are in a catch-22 caused by their banks. Accountants say they cannot sign off on portfolio companies as going concerns unless they have letters from banks reassuring them that credit facilities such as overdrafts will be renewed. Banks, however, are proving reluctant to commit to lending given their own funding constraints. Yet if companies fail to get their accounts signed off by their auditors (or if they are qualified in any way) they may be in breach of their covenants.
Amid such gloom, private-equity firms have given up hope of earning super returns over the short term and most just want to nurse their companies through the downturn. If the banks thwarted that needlessly it would be a shame-not to mention self-defeating.