The long term effects of PE

Private Equity (PE) funds have been in the news for all sorts of reasons recently. On the one hand these ‘locusts’ are under attack from unions, but on the other they are praised by the head of the CBI. While there may be changes to their regulation or disclosure requirements, one thing is certain: the amount of money they have raised and continue to raise will make them a significant influence on equity and corporate bond markets over the next few years.

PE funds raised $432bn last year globally, according to Private Equity Intelligence, which gives them firepower of around $2 trillion if they used 4 times as much debt to buy companies. And estimates suggest they may raise more in 2007, possibly $500bn. We should expect more Leveraged Buy-Outs (LBOs) in 2007, after all 8 out of the 10 largest LBOs of all time happened in 2006 after less money was raised in 2005.

What does this mean for corporate bond investors? Well bondholders of potential targets, likely to be investment grade, should make sure they are protected with covenants so they can get their money back. There are few places to hide when even Home Depot in the US is talked about as a target. High Yield investors are likely to see more issuance to fund the LBOs but should make sure that the PE fund hasn’t overpaid (multiples are rising as shareholders become less willing to be bought out cheaply).

But the more significant effect may be for corporate Europe to take on more debt and fall down the credit spectrum. Companies such as Portugal Telecom, currently being courted by Sonaecom, are offering special dividends funded by debt to fend off a takeover and so you could see their ratings fall to junk even if they are not taken over. This would bring the ratings of European companies more in line with US companies that have typically had more debt. Maybe one of the reasons for European companies having less debt than their US counterparts was a less established capital market for junk rated companies in Europe, but that fear should have eroded with the maturity of both the European High Yield and Leveraged Loan markets that are more able to finance lower rated companies.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

David Fancourt

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