Private Equity Economy

Private Equity, specifically Leveraged Buy-Out (LBO), deals are getting bigger and bigger and there are more and more of them taking place. LBO’s are usually 30% funded through private equity and 70% debt. The debt of an acquisition often comes in the form of syndicated loans and can sometimes reach 90% of the deal. A syndicated loan differs from a bilateral loan in that it involves a number of banks or agents and usually has one leading agent. As we will see later in this essay, hedge funds and other credit investors are more and more present in such loans. These recent innovations in the credit market have helped to provide stability in the world financial system. “In recent years, markets have lived through the end of the internet bubble, the collapse of Enron, the terror attacks of 9/11…Any of these might once have triggered a financial crisis. But none did[1].” Debt and credit derivatives have grown beyond recognition, with new derivatives being created regularly. As they have become more and more complex, they have moved further and further into the “shadows” away from the public eye.

Regulators, among many others, worry that this flurry of complex instruments dealing with lending and borrowing could lead to the next financial crisis. The Economist notes three trends over the past decade that can be rather unnerving. First, companies are raising more and more capital through private equity and private issued loan instruments as opposed to public equity which involves selling stocks or issuing bonds on an open exchange. Private deals are harder for investors and regulators to monitor. Second, lending is “increasingly being orchestrated from outside the regulated banking industry, by hedge funds and other credit investors” which are only supervised indirectly if at all. Finally, although some of this capital makes its way into the hands of a few public companies, a large majority of it is snatched away by LBOs who use the money to buy public companies and take them private. With these credit instruments risk is dispersed “to those who have an appetite for it” which should make the system more robust[2]. This is possibly the reason why the overall financial system has been improved in efficiency and resiliency. However according to Timothy Geithner, president of the Federal Reserve Bank of New York, “the same factors that may have reduced the probability of future systemic events, however, may amplify the damage caused by, and complicate the management of, very severe financial shocks. The changes that have reduced the vulnerability of the system to smaller shocks may have increased the severity of the larger ones[1].”

[1] « In the Shadows of Debt » Economist: 23/09/2006.

[2] “the dark side of debt” Economist 23/09/2006.