Private equity proves to be a risky business

Experts have warned that favourable statistics for private equity deals do
not reveal the full extent of the risks facing the rapidly growing sector.

Leveraged deals have become increasingly popular, and impressive returns have
prompted investors to view these deals as holding particularly attractive
risk-reward characteristics.

During the first nine months of this year, the value of leveraged finance
deals have climbed 24% to £17.5bn, overtaking corporate M&A for the first
time, according to the Centre for Management Buy-Out Research.

Standard & Poor’s, meanwhile, found that only one company out of the 278
it tracked in 2005 defaulted on debt repayments for the year to the end of June.

Although the statistics create the impression that the sector is robust with
relatively low risk, Standard & Poor’s director David Gillmor has warned
that debt market cycles and the increasing use of exotic financing tools posed
risks to leveraged finance transactions that statistics alone could not reveal.

Gillmor said the level of defaults were low because there was an ‘imbalance’
between the supply and demand for debt, creating a market that was ‘very
favourable towards raising debt’.

This, in turn, influenced the capital structure that companies chose to
implement. Groups are increasingly using secondary debt and pay-in-kind loans –
instruments that receive interest payable in the form of additional securities –
to raise capital, and then refinancing these more expensive borrowings at a
later date.

This could see highly-leveraged groups run into difficulty if debt market
conditions turned and refinancing becomes more difficult.

Gillmor said: ‘Second-secured and PIK debt are increasingly common and these
factors decrease the probability of default in the early years of a transaction,
but increase the re-financing risk proportionally.

‘In the current benign environment, such refinancings are very common, and
comparatively straightforward to execute. However, it is not difficult to
envisage a situation where, as market conditions turn, the amortisation
schedules kick in and debt holders become much less confident of achieving
straight forward refinancing.’

Standard & Poor’s believes that these factors will eventually see higher
default rates reflected in default data.

The agency said most industries in the European leveraged finance market
experienced many years of very few defaults, punctuated by a few years of high
default levels. This trend should continue despite the low levels of defaults
reflected in statistics.


Ernst & Young has been called in by HBOS, the bankers of beleaguered music
company Sanctuary, to conduct a viability study into the
group’s future prospects.
Sanctuary was facing a serious loss of capital back in October because of
aggressive accounting practices and HBOS feared for the future of the group,
which represents Morrissey and Sir Elton John among others. Since then the group
has thrown its backing behind a restructuring recovery plan. The company has
brought in corporate finance boutique Evolution to lead £130m fundraising that
is aimed at saving the group. The rescue plan will see long-serving Sanctuary
director Michael Miller step aside.

Online gambling giant PartyGaming will hope the strong recovery
in its share price continues today when it releases a trading statement. Since
the group’s share price fell to below 75p in September, when the group warned of
slowing growth rates, the stock has rebounded to above 115p a share once again.
PartyGaming is, however, in the midst of a legal battle over contracts with
rival Empire Online. The matter is heading for the courts in Gibraltar and the
British Virgin Islands.

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