By Tessa Walsh - Analysis
LONDON (Reuters) - The malaise in the private equity industry is forcing Europe’s banks to explore ways of resuming direct funding to smaller and riskier companies, in an effort to kick-start mergers and acquisitions.
Private equity firms dominated lending to unlisted, low-rated ‘junk’ companies in the boom years of the new century, but can no longer get financing, prompting banks to cut out the middle men and lend directly through a mix of corporate loans and high-yield bonds.
“We will be back to traditional deals with corporate loans provided by banks and high-yield bonds provided by institutional investors,” a senior loan trader said.
Lending to private equity firms collapsed after Lehman Brothers’ meltdown, when it became obvious that companies bought in leveraged buyouts (LBOs) with excess debt could not support their borrowing.
Banks are still unwilling to risk their reputation or capital on new private equity-backed buyouts and the leveraged loan market that financed the LBO binge remains closed.
Companies’ need to refinance and sell units to reduce debt is mounting, however, pushing European firms with ratings of BB/BB- to look at ways of raising money in their own right from banks and investors.
This would bring Europe more in line with the U.S. market, where lower-rated companies rely less on bank loans and are more comfortable raising debt themselves from a mix of sources.
A power shift is underway in Europe as banks refocus on lending straight to companies - particularly strategic trade buyers, to reignite riskier M&A - as troubled private equity firms are sidelined.
Data shows that this move is already underway as fee income from private equity firms dwindles.
Lending to leveraged companies of $35.75 billion (21.6 billion pounds) in the year to date makes up 91.5 percent of the market, with $3.4 billion of private equity borrowing making up only 8.5 percent, according to Thomson Reuters LPC data.
This time last year private equity firms made up 81 percent of the market with borrowing of $65 billion, while $15 billion of leveraged corporate loans made up nearly 19 percent of the market, the data shows.
In addition, private equity firms are facing rising default rates and restructurings, bringing them further losses and forcing them to grapple with fresh equity injections and writeoffs.
Moody’s European speculative-grade default rate rose to 8.2 percent in August, from 6.7 percent in July, and is expected to peak at 11.4 percent in the fourth quarter of 2009.
“Two to three years ago private equity firms were the best clients but there has been a complete reversal. Private equity funds are no longer considered key clients by banks, which would rather employ funds for corporates,” a second banker said.
The high-yield market has issued 6.16 billion euros of bonds so far this year to help companies such as Italian telecom Wind Telecomunicazione to refinance their debt, according to SG research, but has yet to step up to finance new M&A activity.
While bond investors have been supportive, there is no sign of the retail institutional investors that used to buy leveraged loans, after a slump in the value of such loans thinned their ranks from around 200 to around 20.
Collateralised Loan Obligation (CLO) funds -- previously the biggest buyers of loans -- are unable to issue new funds while the price of loans is below par, hampering attempts to bring liquidity back to the leveraged loan market to finance new buyouts.
“The whole mechanic of the institutional loan market is frozen,” a banker said.
Bankers expect the leveraged loan market to remain closed for 18-36 months, a view shared by Former Federal Reserve Chairman Alan Greenspan who said this week that exotic financial instruments such as Collateralised Debt Obligations would not return, even after the crisis is over.
“If Greenspan is right the question is whether the LBO market will ever get back to where it was and find liquidity outside banks,” a second senior loan trader said.
This could herald a boom in high-yield bond volume as institutional loan investors switch into bonds, leaving banks to provide corporate loans as private equity firms regroup.
Leveraged corporate loans will, however, remain expensive, at 350 basis points or higher, which could prove difficult for European treasurers -- accustomed to cheap bank loans -- to accept.
“The LBO loan market will come back as a corporate market. Many loan investors already buy high-yield bonds and they will buy more,” a senior banker said.
Reporting by Tessa Walsh; editing by Simon Jessop