Highly geared

Some private equity bosses are forthcoming about their business.

Peter Taylor, head of Duke Street Capital - a British private equity partnership dealing mostly in medium-sized companies, explains how another piece of financial engineering crucial to the private equity business works, namely gearing.



Provided they [most banks] don't hang on to the loan, they just can keep on: originate, originate, originate, take a fee, take a fee, take a fee

Hugo Dixon, editor of BreakingViews.com

It is called "gearing" because it gears up the returns private equity investors would otherwise get.

For instance, explains Mr Taylor: Suppose he invested £30m buying a company and the value of the company doubled to £60m. That would be a £30m profit to investors - doubling their money.

But, suppose he had borrowed £70m to add to the £30m from his investors, buying a company with this £100m instead.

If that company doubled in value to £200m he would be able to repay the £70m loan and have £130m profit for his investors - more than four times their original stake.

"The higher the borrowing", Mr Taylor explains, "the higher the gearing effect on our returns".

Not prudent

Since the personal rewards for private equity bosses depend on the returns they produce for their investors, it is not surprising that the amount of borrowed money in private equity deals has been increasing sharply.

Mr Taylor believes it is risky to borrow more than five times a company's basic cash flow.



The amount of money raised gets bigger, therefore you can go for bigger targets and the whole thing snowballs upwards

David Matson, IKB Fund Management, London

"We've seen levels of gearing increase to a level where, in some cases, we find it irresponsible," he says.

"There are now a lot of deals being done in the markets with borrowings at seven, eight, even nine times cash flow.

"We think that's too high. We think there are risks being taken there."

Mr Taylor says he is now being offered more debt than he thinks it is prudent to take on.

Transaction fees

But where is the money coming from to fund the huge debts private equity is taking on?



Private equity profits have boomed

Banks used to worry about the how much companies borrowed.

That has changed, and there has been a sea-change in the way most banks now do business, according to Hugo Dixon, editor of BreakingViews.com, a leading online analyst of private equity.

"In the old days, what would happen was that banks would make loans to companies and then they would keep those loans on their balance sheets," explains Mr Dixon.

"If something went wrong with the company, the bank would face a loss on its loan."

Nowadays, he adds, most banks make money from fees for arranging or originating private equity loans, which they then sell on to get the loan off their books.

"Provided they don't hang on to the loan, they just can keep on: originate, originate, originate, take a fee, take a fee, take a fee."

Risk level

Dig deep in the undergrowth of modern financial engineering, and it soon becomes clear where the risk ends up.

There is a channel for the money private equity borrows that is now more important than the banks: the impenetrably named Collateralised Loan Obligation, or CLO.

CLOs hoover up bank loans to private equity companies. Because the loans are mostly to highly borrowed companies, they are rated as risky.

By a fiendishly complex computerised process, CLO managers reapportion the risk into a series of slices.

Each slice offers a different level of risk and reward: from minimal risk with a small return above the base rate to high risk slices offering extra interest of 15% or more.

The slices are then sold to investors around the world - pension funds among them - funnelling yet more cash into private equity

David Matson, a top CLO manager with IKB Fund Management in London, says the CLO market has been growing almost exponentially in the past three or four years.

"The more people that entered the market," he says, "the more money that was raised and therefore you had more money to invest".

From the point of view of private equity operators, cheap, abundant loans make ever larger deals possible, Mr Matson says.

"The amount of money raised gets bigger, therefore you can go for bigger targets and the whole thing snowballs."

Funds collapse

But the powerful loans-pump CLOs have provided for private equity operators may have started to dry up - because of trouble across the Atlantic.

Last month, two large hedge funds operated by the major New York bank Bear Stearns collapsed.

The funds had invested in complex financial structures similar to CLOs, which processed so-called sub-prime mortgages made to Americans with poor credit records, rather than risky loans to private equity companies.

These mortgages were so easy to come by they came to be known as Ninjas - No income? No job?

No assessment of your property? No problem - you qualify for a mortgage.

After the Bear Stearns funds got into trouble, investors began to realise there could be more risk in complex financial structures like CLO than they had realised, explains Mr Ross, a craggy billionaire veteran of Wall Street.

"When the sub-prime problem first started to show, almost every major financial institution very proudly said 'well, its not going to affect us. We don't have any'.

"And then it turns out they all have some and in many cases it was very big. Now, I don't feel that the executives were lying when they said what they said. I think the really scary thing is they did not know that they had it".

Lending crisis

As nervousness among lenders rapidly spread, credit for private equity companies has started to dry up.

Boots' bankers found themselves unable to sell off their loans as they had planned and, across the world, massive private equity deals have begun to run into trouble.

Some deals have already been pulled.

In others, private equity operators will have to pay more for their money, squeezing the profits in their already highly-borrowed companies.

As the jitters of the present lending crisis have spread to world stock markets, it looks likely that the golden days of private equity - with huge rewards for relatively low risk- are over.

At least until the next time a cheap borrowing cycle eventually sets in.


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