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Investment
Quarterly - Q1 07:
Leveraged finance |
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| While
it is doubtful that many alchemists ever managed to transform
lead into gold, private equity partnerships are making a good
go at it themselves with leveraged finance. Iain Morse examines
this potentially lucrative, if risky, proposition |
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Leveraged
finance is now a hot investment topic because of the huge
number and high values of balance sheet restructurings taking
place in North America, the UK and parts of Europe. Merger
& acquisition, the purchase, de-listing and ‘rationalisation’
of companies by private equity funds all need to be financed.
This process, which in the 60s and 70s used to be called asset
stripping, is all about freeing hidden balance sheet value
and making money out of it.
When listed companies take each other over they are bound
by strict regulation to protect the interests of minority
shareholders. Deals of this kind are typically financed by
the issuance of bonds, and secured borrowing from banks. These
restrictions do not apply to privately owned companies. This
is where leveraged finance works at its best and most creative,
stretching the cost of deals to levels that would not be possible
by more traditional means.
Some see this as hugely increasing capital market efficiency,
facilitating deals at prices that could not otherwise be done.
Others, particularly the trade unions and nervous employees,
see it as destructive; the pure play of high finance without
adequate societal protection.
Investors can get exposure to leveraged finance once it is
packaged and sold on by the investment banks. But the two
groups which make most of the money from this process are
the banks and the private equity partnerships which structure
the deals. Leveraged finance is complex with many uses but
the most important of these is that much of the risk in a
deal can be packaged across several layers of debt and sold
on to institutional investors.
Remember that medieval alchemists promised to turn base metal
to gold? Some were burned at the stake for their troubles,
but leveraged finance seems to succeed where the alchemists
failed. It can collect the dross and floor sweepings of debt,
then re package these into far higher investment grade portfolios
of debt. This is possible because leveraged finance is layered
like slices in a cake. The further down you cut the poorer
the quality; at the bottom layer there is no capital security
and a high risk of that coupon not being paid.
Most deals are now routinely financed on this basis. Private
equity partnerships do these deals at the coalface, taking
equity and senior debt along with generous management fees.
The investment banks provide the slick financial engineering
required to pass on much of the cost and risk of these deals
to third party investors. This is an ‘over the counter
trade’, with the debt from individual deals repacked
and combined into new diversified portfolios, sold directly
by banks to their customers. Individually the constituents
of these portfolios may be quite risky, but combined together
they can become far less so.
Investment banks are not under any pressure to advertise or
disclose the terms of these deals. In fact, they are a closely
guarded and very lucrative semi-secret. In the late 90s, the
same banks made huge fees from arranging the initial public
offerings (IPO’s) of high tech firms. Now they make
the same kind of money from these re-structuring deals, with
low interest rates, five years of uninterrupted economic growth
and booming asset values creating the environment in which
this can take place.
Despite initial reluctance, institutional investors have all
been forced to look at ‘new’ asset classes like
leveraged finance as a means of enhancing their returns. The
corollary of this is that the return on lower risk government
and investment grade corporate debt has been compressed to
very slim margins. In this brave new world of endless growth
and low interest rates, leveraged finance suddenly looks like,
well, gold.
But interest rates are creeping up. Growth, though strong,
is not quite as strong as it was. Central banks, which set
interest rates, are becoming a little concerned that inflation
may be coming back into the world economy. Yet still our capital
markets are relentlessly renewing themselves, entering a new
accelerated stage of evolution now facilitated by high growth
in the assets under management in the hedge fund sector.
Here and there a Doubting Thomas will point a finger and utter
dire warnings of how and where this will all end in tears.
But we still have a huge, un-exhausted appetite for leveraged
finance. Will it end badly? Perhaps but only one thing is
sure. Alchemists were burned at the stake. The investment
bankers are earning huge bonuses. If they are burned, it will
only be by the sun on some exotic beach.
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