The Bank of England has highlighted the danger posed to the UK economy by the raft of highly-leveraged companies acquired by private equity pre-crisis, arguing the “fragility of the corporate sector” that has resulted could impact “the resilience of the financial system”.
Private equity-owned businesses in the UK are currently servicing £160 billion (€173 billion; $224 billion) of debt, £32 billion of which will need to be refinanced by 2015. That could lead to a raft of insolvencies and defaults, with follow-on implications for the banks that issued that debt.
It also impacts growth in the corporate sector, the report said.
“Higher debt levels could make companies less likely to undertake long-term investment if that investment is crowded out by the costs of servicing debt,” explained David Gregory, author of the Bank of England report. “Lower investment affects the productive capacity of the economy and could therefore have an indirect effect on the financial system via lower long-term corporate profitability.”
Evidence of a link between private equity ownership and distress should most clearly become apparent in insolvency rates, he added. But while insolvencies in the UK have accounted for around 30 percent (in unweighted terms) of private equity exits since 2009, these made up less than 1 percent of overall UK insolvencies.
“Given the large build-up in debt before the financial crisis, a larger rise in insolvencies might have been expected. The low level of interest rates combined with the practice of bank forbearance are two possible explanations for this,” the report said.
“A distressed corporate sector can have an adverse impact on the health of the financial system,” said Gregory. “The refinancing challenge associated with the approaching hump in maturing debt compounds this risk,” he added.
The need to refinance this substantial portfolio of debt could however provide an opportunity for private debt funds keen to gain exposure to the UK market. In addition, defaults could lead to opportunities for distressed debt funds, many of which have raised substantial amounts of capital but have yet to see the supply of opportunities match demand.
Private equity-owned businesses represent about 5 percent of the corporate sector by total assets but account for 8 percent of the total corporate debt, according to the report. Private equity-owned companies were therefore on average more highly-levered than other corporates.
Cheap credit fuelled the buyout boom in the mid-2000s, and the BofE singled out the banking community as a result. The report found a significant factor in the dramatic increase in the quantity of buyout debt was the ‘originate to distribute’ model. Banks originating leveraged loans became less focused on the inherent risks of the transaction and more focused on collecting arrangement fees.
“The growing importance of larger deals coincided with a loosening in credit conditions on lending used to fund acquisitions by private equity companies. Banks started to relax both the price and non-price terms and conditions of these loans in order to compete for business.”
The BofE did however argue that leverage can have a positive impact on a company. Greater leverage means regular (and higher) interest payments, reducing ‘free’ cash flow. Lower free cash flow can help to exert discipline on company management by removing resources that could otherwise be used by management to invest in negative net present value projects, the report suggested.