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Sense of the markets: Really risky business

by David Carey | Published October 14, 2011 at 10:59 AM

The slowing domestic economy, Europe's debt crisis, lately balky leveraged finance markets and the topsy-turvy dance of stocks since July have staggered normally surefooted private equity players, making them puzzle over the future and how best to proceed.

Their disequilibrium was on display at a panel discussion in Manhattan last week of private equity and credit market investors and advisers put on by the New York chapter of the Association for Corporate Growth, a middle-market trade group.

Market signals, the panelists noted, are decidedly mixed. Default rates are near record lows. Yet junk bond and loan yields have widened by a percentage point or two. The pullback in debt has forced buyout sponsors to kick in more equity to get deals done, as evidenced by Carlyle Group and Hellman & Friedman's putting up 45% of the funding for their $3.9 billion leveraged buyout of Pharmaceutical Product Development Inc., announced Oct. 3. Even so, better-rated leveraged buyout loans trade in the secondary market at fairly low discounts to par, and deal valuations are close to those of the mid-2000s market peak.

Thus far, the latest eruption of anxiety has expressed itself as a flight to quality, as investors jump from shakier credits to more solid credits.

The jitteriness shows no signs of escalating into a full-blown panic of the kind that sent asset values plunging, spawned a wave of defaults and shut down the credit markets in the aftermath of Lehman Brothers' 2008 collapse. None of the ACG panelists believed that it would.

That's not to say. however, conditions won't worsen if the economy further weakens and the crisis in Europe isn't contained.

"I think the risk is not so much that we have a return to an outright recession, but that we have years of very low growth, a Japan-like scenario," said panelist Blake Hornick, a securities lawyer at Seyfarth Shaw LLP.

"The challenge for dealmakers and policymakers is how to navigate through a high-unemployment, low-growth, deflationary and to some extent absurdly low interest-rate environment."

Two PE dealmakers put the cheeriest gloss possible on the gloom. Asserting that "the most glaring vulnerabilities equal the best opportunities," Churchill Financial's Randy Schwimmer argued that PE firms can profitably step in and furnish small businesses with vital financing that banks have stopped providing. Sterling Partners' Danny Rosenberg opined that buyout players with a stomach for risk can generate good returns whipping into shape operationally challenged midsize and small companies.

To those assessments, Sound Harbor Partners LLC's Michael Zupon, a debt investor, added a dash of caution born of grievous experience. Though he didn't bring it up, most in the audience knew that back in 2008, when he worked for Carlyle, Zupon had been a key member of a team that put together a $20 billion leveraged portfolio of supposedly high-grade residential mortgage-backed securities that ended up imploding. As the saying goes, once burned, twice wary:

"There is a real risk we could be in for a very, very difficult environment" with a tide of defaults, said Zupon. "You might have missed it the last time, but no one is going to miss it this time. For me, the risks are much higher and you've got to move up in the capital structure" and invest in secured and safer debt tranches.

The overall message: Though cause for optimism still abides, it is in peril and a tough road likely lies ahead.

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Tags: bankruptcy | Europe's debt crisis | leveraged finance | loans

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Sense of the markets: Really risky business

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