One reason the market hasn't fallen further is liquidity. The U.S. and International markets are awash in cash. It is easy to borrow at low rates. Until credit is tightened, it will be difficult for the market to sustain a significant correction.
Heavily leveraged Private equity and hedge funds are trolling the markets looking for any arbitrages or acquisitions. As the amount of money chasing opportunities increases so does the risk. It will become more and more difficult for these groups to deliver the 30% plus returns their investors have come to expect. This wall of cash may cause dislocations (deals done at unsustainable premiums) that will hasten a correction. The back end of all this will probably not be pretty.
A credit squeeze will of course also hasten a correction by drying up this excess liquidity.
Here is an interesting article that discusses this topic in greater detail.
The Financial Pragmatist
Libby Mihalka
Has success spoiled private equity?
By Sharon Reier
Friday, March 23, 2007
'Fortune favors the bold," wrote Virgil, the classical poet who glorified the power of Rome. These days few are bolder or have gathered more fortune than the private equity groups that have accounted for more than 20 percent of the merger activity so far this year in the United States and a growing proportion of it overseas.
But just as a string of record-breaking private equity bids made news from Britain to Australia — and major firms like Blackstone Group prepared initial public offerings of shares to individual investors — the risks were also climbing. Experts are apprehensive that the current easy financing via low-grade, high-yield debt could become more costly and less secure, while political opposition to the swashbuckling ways of private equity is growing.
This is not the way that the elite, insiderish, secretive private equity club might have expected things to go. But the changes reflect the fact that private equity is now in the mainstream of capitalism, and will increasingly be expected to play by the rules.
"Given the size of the industry, the level of public scrutiny has reached unprecedented levels," said Javier Loizaga, chairman of the European Venture Capital Association, at a meeting of private equity investors in Geneva this month. "Not everybody likes us. Not everybody will like us."
Certainly over the past few years private equity has delivered superior, and sometimes outstanding, returns on investment. Long-term the funds look for 15 percent returns after fees, better than investors have done in the equities markets, said Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at the Tuck School of Business at Dartmouth. But over the past three years, some of the better-known firms like Blackstone and Carlyle Group have achieved annual returns of 40 percent and higher on some deals.
The theory behind private equity is that the ownership model is better and more efficient than the traditional public-shareholding model. "Asset managers and equity investors are pretty passive," said Pierre-Etienne Lorenceau, publisher of Décideurs, a magazine that covers private equity. "Investors depend on the communication policies and bullishness of the CEO and the mood of the market, and it is a very uncomfortable position."
Private equity, by contrast, gives control of the company to a small group of people: general partners, or the executives who run private equity firms and take the bulk of the risk and reward, and limited partners, or investors in private equity funds. The limited partners "know their money will actually be at work," Lorenceaux said — because if it isn't, the general partners will not hesitate to fire management or sell the company.
The sound bites may be new, but the structure is not.
In the 1980s, enabled by high-yielding junk bonds, leveraged buyout funds bought public companies with small amounts of equity and dollops of debt. Some returns were spectacular; other deals crashed. The poster child for failed deals was the $30.6 billion hostile takeover of RJR Nabisco in 1989. Chronicled in the book "Barbarians at the Gate," the deal barely eked out a profit for the winner, Kohlberg Kravis Roberts — in large part because KKR overpaid in the first place, and because problems in the junk bond market in 1990 made it impossible to refinance the debt.
Over the past few years, the financial stars have been aligned perfectly for private equity deals. Able to buy assets at low prices earlier in the decade, firms displayed an impressive ability to leverage the deals with debt, then re- leverage them to pay a dividend to investors or sell them in IPOs and to other private equity companies.
Enticed by high returns, investors like pension funds, insurance companies, funds of funds and wealthy individuals deluged private equity partnerships with money. Last year the firms raised $432 billion to put to work in deals.
Supplementing that war chest is the great wall of money available from income investors, desperate for higher yields than they can get on investment-grade credit, who have eagerly invested on the debt side. So eager have they been to buy into these leveraged loans — packaged into collateralized loan obligations, known as CLOs— that they have accepted relatively low premiums over base lending rates.
Buyers of this debt have also taken on the additional risk of what are what are being called "covenant-lite" terms. Covenants set forth legal guidelines concerning financial measures like ratios of debt to cash flow. Covenants enable lenders to declare borrowers in default if guidelines are violated.
"This is unprecedented," said Ray Kennedy, managing director of high-yield investment at Pacific Investment Management, or Pimco. "I don't think we have ever seen this level of give-ups."
The result of this overheated lending is that it has created a silly season in which private equity firms have been able to increase leverage from five and six times cash flow to as much as eight and nine times, greatly increasing the stakes — and the returns needed to pay off the debt.
It has also enabled the firms to contemplate bigger deals, like the blockbusters announced this year: $45 billion for the Texas utility TXU; the much-discussed £11 billion, or $21.6 billion, bid for the British supermarket icon J. Sainsbury; a bid of 11 billion Australian dollars, or $8.9 billion, for Qantas, the Australian flag-carrier airline.
Bigger deals, of course, mean higher fees. And Blackstone's public offering will give investors the chance to participate in the profits along with management.
But individuals will want to look before they leap into any private equity investment, experts warn, as the chances of a major change in the financial climate are increasing — thanks in part to the debacle in U.S. subprime lending market, which has cast all risky loans under a cloud. Last Friday, in fact, J.P. Morgan Chase recommended that investors reduce their holdings of collateralized loan obligations backed by high-risk, high-yield loans — the kind of debt typically used to finance leveraged buyouts.
So far the top private equity firms are confident that they can get these deals done because of continued liquidity from oil money, government surpluses from Asia and the Middle East, and hedge funds, according to Edward Altman, professor of finance and director of fixed income and debt research at the Salomon Center at New York University.
But Altman, who studies what he calls the "mortality rate" of debt, warned that more than 50 percent of the loans tied to highly leveraged transactions in 2006 involved companies whose bonds or loan financing received a CCC rating, the lowest and most risky given to new financings.
"Traditionally these result in a fairly high default rate," Altman said: A third of CCC- rated bonds default within three years of issuance, and about 50 percent default within five years.
"Investors have been accepting spreads far too low for the risk involved," Altman said.
The fact that creditors have been accepting fewer covenants on this kind of debt also means more risk — and, potentially, more recklessness. Kennedy at Pimco said that "a company could have a bad string of earnings and there would not be a default. And such conditions will mean that management teams can take more risk and won't have a lender breathing down their necks."
Then there is the growing chorus of criticism as the private equity model spreads globally. Reactions by labor groups in Europe have tended to be particularly sharp: Private equity firms are estimated to indirectly employ 19 percent of private sector workers in Britain, according to a study by the British Venture Capital Association, and between 7 percent and 9 percent in France, according to French unions.
"In Europe if people see you are getting 25 percent of 30 percent returns, they say: 'What is going on? It can't just be management wizardry,'" said Adam Lent, head of economics and social affairs for the Trade Union Congress, a federation of 62 British unions representing 6.5 million workers. "The question we are raising is, 'Who is bearing the risk?' We are pretty sure that it is not the 10 or 15 men who run the funds."
But as always, private equity is trying to keep ahead of the curve and increasingly is moving into emerging markets. Last year KKR did the largest major leveraged buyout in India — the purchase of the software business of Flextronics International for $900 million — and more private deals are thought likely to follow. Sabine Schaffer, vice president at Evolvence Capital, a private equity company in Dubai that has many investments in India, said that the prevailing view is one of cooperation.
"They are not seen as locusts," Schaffer said, referring to the epithet applied to private equity by a German politician, Franz Müntefering, in 2005. Today in India, Schaffer said, "the economy is booming. You won't see people being upset about any of the deals."
And until a major deal goes wrong, or the debt market closes, expect private equity firms to raise even more money and remain hyperactive.
"The attitude in the industry," Blaydon said, "is that when the cookie tray gets passed, you've got to take some."
Copyright © 2007 The International Herald Tribune www.iht.com
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