I trust readers don’t mind the high proportion of Financial Times stories today. You’ve probably figured out that the FT often runs stories that don’t get reported in the US.
While the title of this post is a bit of a mouthful, the concept is pretty simple. As you know, the pricing of risky credit has been very aggressive of late, or to put it more simply, doggy borrowers are getting astoundingly good terms (although with the wreakage in the subprime mortgage market and the China-led fall in global stock markets today, we may be seeing the beginning of the end of this trend).
One consequence that hasn’t been noted heretofore is the effect it has had on private equity firms. One of the legitimate concerns is that a private equity firm could simply load up an acquired company with a lot of debt, pay itself a big special dividend, do some short-term, unsustainable cost cuts to make the results look artificially good, and dump the company back on the public markets (you’d think the markets would be smart enough to assign an appropriately low price to a debt-ridden IPO, but never underestimate the ability of a good road show to dress up a bad investment proposition). Moreover, if they can pull out enough cash, the buyout firm does not need to sell the company to realize a good return. Any proceeds upon sale is gravy.
Tony Jackson, in “Derivative risk threatens private equity,” explains how one of the checks on private equity firms overleveraging an acquired company, namely, the prudence of banks making the loans, no longer works the way it did before. (As an aside, one can’t necessarily rely on bank conservatism either. In the last big buyout cycle of the mid-late 1980s, banks lent to quite a few dodgy deals that later went bust, simply because they were keen to book the huge up front fees thay paid. So if the not-so-good old days look comparatively good, you can imagine how frothy things are now, at least in the credit markets).
Jackson describes the role of collateralized loan obligations, and how their pricing says that no one is taking risk into consideration:
In practice, it is perfectly possible for private equity to load a company with excess debt, then strip the cash out as a dividend. If this is done on a big enough scale, the fund can profit handsomely even if the company goes bust.
In previous cycles, there was an obvious safeguard against this: the banks would not lend more than a company could bear. But that has all changed with the advent of credit derivatives.
Today, a bank can grant a leveraged loan with impunity, since it can offload the credit risk. And market demand for that risk is insatiable. The form of credit derivative known as the collateralised loan obligation, or CLO, feeds on just such loans. Hence presumably the fact, as reported by Standard & Poor’s, that there is no known case lately of a European issuer of a leveraged loan failing to get it placed.
In itself, this kind of securitisation of loans – the spreading of risk across the investment community – is a natural enough development, and not obviously harmful. But the problem right now is that the credit derivatives market seems to have taken leave of its senses.
Some recent work by Absolute Strategy Research illustrates the scale of this. As is well known, premiums on credit default swaps (CDSs) have been falling for several years, and are now at an all-time low. In other words, the cost of insuring against default is increasingly negligible.
What I did not know, though, was how differentials between different types of risk had fallen as well. Across Europe, it appears, premiums for cyclical stocks and industries are now almost the same as for non-cyclicals. That is, the cost of insuring against default is almost the same for industrial or high-tech companies as it is for pharmaceutical firms or utilities.
If that sounds daft, so does the fact that over the past year, premiums on 10-year CDSs have fallen markedly in relation to 1-year CDSs. So as the expected turn in the credit cycle has failed to materialise, it seems investors have come to assume it never will – or not over the next decade, anyway.
The reality, no doubt, is somewhat less rational. What we have here is our old friend, the hunt for yield. Bigger risks offer a bigger return, so bid up those risks and depress the return.
If that seems rather remote from our starting point, consider the link once more. Private equity houses are in a position to overload companies with debt because at the other end of the line, those underwriting the risk are quite insensitive to the dangers this poses.
When the music stops, of course, a lot of people will get burnt – most obviously, holders of credit derivatives. But some private equity houses will presumably get caught as well, if they have not managed to extract enough cash before their companies hit trouble.
And the fallout could be a lot wider. Pension funds are big investors in private equity, and some dabble in credit derivatives. Pensioners aside, people in bankrupt companies are going to lose their jobs, without any benefit to the economy whatever. And if that happens, the abuse we are seeing today will only be a taster.