Yesterday we told of our fears that the sub-prime mortgage crisis in the US was spilling over to hit hedge funds and private equity. In the US traders hit the panic button over the news, as bond guru Bill Gross said markets were due for a correction of between 5 and 10 per cent, and JP Morgan said that the market for collateralized debt obligations (CDOs), that’s loans which are used by hedge funds and private equity, had seen sales fall dramatically between June and July.
Now news has broken to justify those fears.
In the US, Cerberus Capital Management, which is in the throes of buying US car maker Chrysler, is struggling to raise the money it needs. In all, the private equity firm is trying to raise $20 billion, with $12 billion coming from a bankers syndicated loan. But yesterday, news broke that bankers were struggling to rustle-up sufficient interest, and the issue of the loan has been postponed
No one is questioning whether Cerberus will eventually raise the necessaries, but the difficulty it is having shows how conditions have changed. Earlier this week, Bill Gross said that he had heard the private equity company is being forced to pay out debt equating to a 9 per cent interest rate, and even higher for parts of the debt, whereas, when the deal was first agreed, it was expecting to offer interest payments of around 7.5 per cent.
And then, on this side of the pond, the purchase of Alliance Boots by Kohlberg Kravis Roberts Co, the biggest buyout in UK corporate history, hit a hurdle.
The deal is being backed by a syndicate of banks made up of Deutsche Bank, JP Morgan and UniCredit (HVB) and Barclays Bank, Citigroup, Bank of America, Merrill Lynch and Royal Bank of Scotland. And yesterday this powerful coterie failed to raise the £5.1bn of senior debt they were after.
Now they are looking at raising the debt using different instruments offering a higher yield, or alternatively, may actually have to put the money where their mouths respectively sit, and fund the deal from their own coffers.
The problem with these CDOs is that they may not spread risk quite as much as their backers think. In the event that the business venture being backed fails, or is unable to meet its loan obligations, then the creditors don’t take too big a hit, as they have managed to spread the risk over as many financial institutions as possible.
Is is possible, however, that because risk is spread, an element of complacency has been created. Maybe deals are being funded at a rate that would not be considered viable if the funding was provided by just a few lenders. This in turn has led to the danger of over-gearing in the corporate world - making private equity businesses more vulnerable to an economic slowdown.
If three people decide to lend you money, and you go bust, then each of those people will only take a third of the hit. But supposing those three people lend money to three people, and all three went bust. It’s a different matter then.
By spreading risk, and therefore offering more lax credit conditions, lenders have unwittingly increased the chances of wider business failure, and in the process merely spread their potential losses, so that they are harder to predict. Business failure on a micro scale may not matter so much when debt has been syndicated. But, on macro scale, debt syndication may merely syndicate over-confidence.
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