Drivel and Debt

That illustrious organ The Economist has a cracking cover this week with a man reading his blackberry at the pinnacle of a mountain totally unaware that he is about to step off into the abyss and the tagline reads: ‘The trouble with private equity’. The story behind the headline is a disappointing rehash of the front pages of the broadsheets over the last two months. The leader offers this wishy-washy explanation for the trouble with private equity:
“It is possible that the debt that powers private equity is starting – just starting, mind you – to become harder to scrape together. It may not happen this month, perhaps not even this year, but sooner or later the private-equity boom will come to an end.” 
Thanks for the insight. Not! So what is really happening with the debt situation?
Economists, real ones not the magazine, forecast that interest rates in the UK will hit 6% by the end of 2007 as yesterday’s fifth increase in a year took the rate to 5.75%. Many believe that the rate will hit 6.25% in the first quarter of 2008, a cash cost unseen in this country for the past decade. And the hikes aren’t stopping with the Bank of England – another increase is also likely in September from the European Central Bank.
It is possible that these rate rises may not affect the larger buyout houses whatsoever as data from the Bank of England, revealed by the Treasury Select Committee (TSC), suggests some private equity houses were able to borrow beneath the base rate on large deals. But Dominic Murphy, a partner at KKR, said to the TSC: “I am not aware of anybody being able to borrow beneath the base rate; that is news to me. I’m not saying that the bank is wrong – I’m just not aware of it.” He added: “I’d love to borrow at those rates.”
For the majority of private equity houses active in the UK, these rate rises will make existing leveraged deals more difficult to service though many leveraged buyout houses mitigate interest rate risk through hedging. But in an extreme case, a leveraged company will be pushed up against its banking covenant, according to Jeremy Walsh, the head of banking at Travers Smith. “New deals will be more difficult to do as the cost of leveraging increases,” he adds.
At the moment, sellers are able to command high prices because they know that private equity houses can borrow so much money but those prices will have to be adjusted as interest rates increase, according to Walsh, though there is still lots of competition and high liquidity.