IMF: more pain in store for PE

The leveraged loan market could be gearing up for a crisis similar to the one that rocked the subprime loan market this year, according to the International Monetary Fund's semiannual Global Financial Stability Report.

The IMF said in the report that it sees similarities between credit weakening in the

nonprime mortgage market and that in the leveraged loan market.

“Analogous to the innovation in the nonprime mortgage market, financing innovations – such as covenant-lite loans and incurrence covenants – allowed more marginal firms to be considered as targets, and encouraged deal sponsors to buy companies at higher earnings multiples,” the report said.

As a result of these innovations, more than one-third of buyout targets were rated B or lower by two agencies by the second quarter of 2007, and 30 percent of leveraged loans were covenant-lite, the report said.

The subsequent weakening of the secondary markets also parallels the course of the subprime crisis, and suggests that recent deals will likely face refinancing difficulties.

“The analogy with resets in the mortgage market suggests some firms may struggle to secure financing on attractive terms, and may therefore have to carry a more demanding debt service burden than anticipated. Defaults are therefore likely to rise,” the report said.

The unwinding of leverage in these conditions could spread volatility across markets, affecting hedge funds, structured investment vehicles, and asset-backed commercial paper.

The IMF also predicted that private equity firms would compete for fewer deals in the future as increased interest rates and stricter terms force firms to invest more selectively.

“It appears that private equity has picked most of the 'low hanging fruit', potentially straining the viability of targets in the period ahead,” the report said.