The Bank of England is not known for its hyperbole. It has always maintained that it warned of the dangers of sub-prime mortgage securitisation long before the capitalist model nearly imploded. Alas it couched its warning in words of such subtlety that that few people noticed, and indeed it would not be surprising to learn that many fell asleep while reading documents that had the economic equivalent of dynamite hidden in their midst. Well the Bank of England has done it again. It has hit us with the full venom permitted within the constraints of its latest quarterly bulletin. I put matchsticks under my eyelids, topped myself up with Dr Pepper, and read its latest warning. And by the time I had finished, I needed to take something far stronger to calm down.
It was back in 2007 when I read Galbraith’s book ‘The Great Crash of 1929’. In it he devoted a chapter to the dangers of leverage seduction. In 2013 I don’t think it is necessary to spell it out: we all get it, I think. When assets prices keep going up, leverage can offer a remarkably quick route to riches. But when asset prices begin to fall, things can implode faster than you say Lehman Brothers. The same week I read Galbraith’s book I attended a lecture on the wonders of private equity. I am afraid I put two and two together, and got three. Or maybe it would be more accurate, to say I made two mistakes in my addition, which cancelled each other out. I got the answer right, but my workings out were wrong. My reasoning back in 2007 was that leverage was dangerous and that private equity was a bubble. Once it unwound, the result would be a financial crisis on a massive scale. Of course, we had a leverage backed bubble in US sub-prime, not private equity.
It has consistently surprised me how private equity has avoided being caught up in some kind of monumental disaster.
Nassim Taleb has a thing to say about leverage. He was the author of ‘Fooled by Randomness’, a book I really rate; the ‘Black Swan’ which I don’t think is quite as good as many say it is, and now new book called ‘Antifragility’. Taleb has an enormous following these days, and can number a certain David Cameron amongst his disciples. In fact, a few years ago a gushing future prime minister of the UK interviewed Taleb at the RSA.
Taleb does not like debt. He cites as an example how nature has given us two kidneys. If God had worked in private equity, suggests Taleb, we would be given one kidney to share around a dozen or so people. It is a bit like the Graeae from Greek mythology – the three witches were sisters to Medusa and only had one eye between them. Anyway, Taleb reckons the reason why the crisis of 2008 was so much more damaging than the dotcom crash, was that the dotcom boom was funded by equity and the finance bubble by debt. Taleb says debt carries inherent dangers and always poses the risk of some kind of future melt-down.
The supporters of private equity say that because they load a company up with debt, they force it become more efficient, and that the discipline of forcing debt repayments makes companies more profitable.
Private equity’s critics say it is by its very nature short term, because the backers of a buy-out look to exit within a few years. Its supporters say that no such exit strategy will work unless the company in question has a sound long-term plan.
I retain my doubts about private equity.
That is why the latest Bank of England quarterly bulletin worried me. Here are some key points from the report.
The current rate of private equity insolvencies has been surprisingly low, but the Bank of England speculated that this may have been down to “low level of interest rates combined with the practice of bank forbearance.”
On the subject of forbearance, the report stated: “There is evidence from a recent FSA study that the practice of forbearance is particularly widespread on debt exposures associated with private equity sponsored acquisitions. This study revealed that around a third of the £35 billion of major UK banks’ leveraged loan exposures to European companies are benefiting from forbearance.”
But this is the quote I find most concerning: “The refinancing challenge is exacerbated by the fact that, for much of the debt related to private equity acquisitions, a large lump sum will need to be repaid when loans mature. Some LBO [leveraged buyout] debt is amortising — that is, the principal is repaid over the life of the loan. But a substantial portion is structured as a ‘bullet’ repayment: the principal is only repaid at the date of maturity. Of the £160 billion UK leveraged loans that were originated with a maturity of 2012 or later, £14 billion, or 9 per cent, are amortising, meaning that only a minority of leveraged loan exposures will have been paid down after origination.”
Of course in the past, when a loan expired and a debtor could not afford the debt, the solution was easy. The debtor took out another loan. But as the Bank of England said: “Market contacts also point out that many banks are constrained in providing refinancing options given their focus on balance sheet repair.”
And finally: “The average maturity of UK LBO debt is around seven years. Given that the peak in debt issuance was around 2007, there is a significant ‘hump’ of maturities from 2014… As it currently stands, £32 billion of LBO debt is expected to mature in the period 2014–15, with a further £41 billion in the period 2016–18.”
If you glanced at Medusa – the sister of the highly leveraged Graeae – you were turned to stone. I fear there is a danger that the wall of money that was invested into private equity may yet come tumbling down.
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