Private equity groups are getting into increasing levels of debt when buying new companies, according to a warning from credit rating agency Standard and Poor's.
Leverage multiples, which show the relationship between a company's debts and its core earnings (ebitda), have reached an all time high over the last few months. In March of this year, the figure stood at 5.73, and current deals are reflecting still higher levels with the Royal bank of Scotland, HG Capital and EQT all selling debts at over 7 times ebitda.
The figure is showing no signs of slowing down, with Dutch cable group Casema, which is owned by the Carlyle Group and Providence Equity Partners, reportedly considering a financing package with a leverage multiple of over 8.
Although investors do not seem to be too worried as yet, mainly because loan rates continue to be very favourable, there is some concern among analysts that should interest rates rise or the economy slow down, these firms would struggle to pay back their debts.
Questions are also being raised about whether banks and investors are conducting adequate due diligence and thorough assessments when embarking on high-risk deals. The banks, meanwhile, are attributing the increase in the leverage multiples to a higher proportion of cash-flow companies on the market and low levels of capital expenditure.
In addition, risks are also rising for investors with regard to the way private equity deals are structured. Lawyers have noticed a trend in the legal documentation of recent deals whereby there could be loopholes should the company go into default. Although this has not really been tested yet, owing to the small proportion of defaults over the past few years, companies may be able to resort to the sale of key assets to satisfy creditors, and the creditors themselves may struggle to gain the authority to seize control of a company.
However, with defaults set to rise over the next year, this could all spell conflict between private equity groups and hedge funds over leveraged loan agreements and lead to a drop in private equity activity. So far, the warnings are not being heeded, but with the law firms set to profit from any legal tussles, the 'dirty little secret', as one lawyer has termed it, may be out sooner than anticipated.
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