Rising debt levels place companies at risk

Financial directors need to start paying almost as much attention to the holders of their debt as they do to their shareholders, debt advisers have warned.

Over the past year, debt trading has flourished in Europe, as the holders of debt have sought to reduce their risk exposure to particular sectors and regions.

Executives, however, are unaware of the potential impact this phenomenon could have on their companies.

Low interest rates have seen companies carrying more debt on their balance sheets. According to the Centre for Management Buy-Out Research, more than 50% of UK buyouts were funded by debt in 2004.

Research by Close Brothers, meanwhile, found that FTSE250 companies were carrying higher levels of debt than five years ago. The merchant bank said that average gearing in the FTSE250 was 4.1 times earnings before interest, tax and depreciation (EBITDA), up on the 1.75 times the EBITDA figure revealed in a report in 2000.

In the report The growing importance of debt in European corporate transactions Ernst & Young said that as long as interest rates remained low and trading conditions were healthy, companies with high gearing would remain safe.

But if interest rates climbed from their historical lows and the economy slowed, these companies could find themselves in trouble.

Their shareholders, who are traditionally the focus of management’s energy, would be replaced by the holders of their debt in the pecking order.

‘As soon as a company runs into trouble, the balance of power shifts dramatically in favour of those holding its debt rather than its equity,’ said an E&Y spokesperson, adding that many investors were aiming to take hold of a company by purchasing its debt rather than its equity.

Nick Hood, partner at corporate recovery specialists Begbies Traynor, said company directors, particularly in smaller plcs, were not aware of the growing importance of debt in their capital structure and the implications of their debt being traded.

‘It is paramount that executives understand the importance of debt, because when your debt is traded you never quite know what you are dealing with. Unlike banks, the buyers of debt have varying agendas,’ Hood said.

Neill Thomas, head of debt advisory at KPMG, said that private equity-backed companies were most likely to run into trouble because of high gearing. ‘Generally speaking, quoted companies are sensibly geared. Private equity companies are the most vulnerable, especially if they operate in sectors where trading cracks appear,’ said Thomas.

COMPANY REPORTS

FTSE100
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FTSE250
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