2014 Predictions: Debt markets

Private equity returns may suffer as a result of the recent liberal debt markets, says FFL chairman Tully Friedman.

One of the most important things to watch in 2014 will be the performance of private equity portfolios built during the recent period of liberal debt markets.

For the past two years, risk has been under-priced as a result of the US Federal Reserve’s expansive policies. This will certainly change, perhaps sooner than later. Cheap debt, combined with record equity availability, has caused deal prices to spike and stay high for some time. Private equity portfolios are now heavily populated with highly leveraged deals that, in many cases, look expensive.

If the economy weakens and company earnings deteriorate, what will the impact be on these portfolios?  A reduction in values, most certainly. But will it be temporary or permanent? And will lenient terms and light covenants mean that there will be less financial distress than in the past? Putting it another way, will PIK-toggle and covenant-lite terms shore up these companies in the next downturn? We will most certainly find out.

The classic outcome as you get to the top of one of these private equity cycles is, almost inextricably, [that] returns are going to be driven down. History has shown that the pace of investment doesn’t slow down during these periods, particularly if leverage is still available. It may actually accelerate.

Tully Friedman is chairman and chief executive officer of FFL, a US mid-market private equity group