The International Monetary Fund has provided further ammunition for opponents of the private equity industry in Europe by suggesting that leveraged buyouts are one of the biggest threats to global economic stability.
The IMF’s Global Financial Stability Report, which warns that the collapse of a highly leveraged private equity-backed business is increasingly likely, has already been seized upon by the GMB trade union in the UK. The union cited the report in support of its thesis that Kohlberg Kravis Roberts’s £10.1 billion bid for Alliance Boots, a UK health and beauty chain, is over-leveraged and would ruin the company.
The current wave of LBOs is not like that of the 1980s and the late 1990s, the report said, because the size of the deals being done is much larger. Furthermore, rising leverage levels and changes to the typical structure – which now tend to incorporate more leveraged loans and fewer high-yield bonds – has significantly altered the distribution of risks.
The IMF argues that the industry has been lulled into a false sense of security by the benign economic conditions, including the wider availability of debt and historically low interest rates. This has encouraged buyout firms to increase leverage and take greater risks, it says.
However, although the industry has assumed that the current low risk conditions will continue to be a permanent feature of the financial landscape, this could all change in the event of a large high-profile deal running into difficulty, it said – whereupon dealmakers and their financial backers were all at risk because the companies concerned would become extremely vulnerable to economic shocks.
The IMF is concerned that rising interest in the sector has led to more funds chasing fewer attractive deals. This competition means that prices are being bid up to levels that represent historically high earnings multiples, while the greater quantity of loans being issued make an increase in defaults increasingly likely.
It is also worried that the due diligence performed by some investors is weakening as the need for deals increases. It believes the industry’s recent success has led to a weakening of credit discipline and to less stringent agreements between lenders and buyout firms.
The solution is to improve awareness, the IMF believes. “The risks associated with market participants’ increased risk-taking are best addressed through policies aimed at assuring that participants adequately understand the risks they are taking, so that the likelihood of abrupt reversals in behaviour is reduced”, the report said.
The IMF’s thesis receives some support from the latest figures from Standard & Poor’s on the amount of US debt affected by fallen angels, companies whose debt has been downgraded from investment grade. The ratings agency said the volume of debt from fallen angels so far this year has almost tripled compared to 2006, hitting $29.5 billion thanks to a number of private equity buyouts – most notably the downgrade of US utility TXU.