Monday, July 09, 2007

The end of leverage ?

Blackstone Group units, ever since its debut at the US markets on June 22nd, had been closing below the $31 price the private equity giant fetched in its IPO, as investors fretted the private equity boom may have peaked. Some observers attributed the recent weakness to concerns about Blackstone's (Charts) lofty valuation, and a bill in Congress that would raise the tax rate on the profits of publicly traded PE firms to 35 percent from 15 percent.

Normally many in the PE industry would dismiss these concerns as unfounded. In fact the industry had grown exponentially even as its critics were working overtime. For them availability of cheap credit by way of leveraged debt to finance those buyout deals and infuse funds into the working capital of portfolio companies was what mattered. But now the worry is precisely that – cheap credit has been drying up owing to rising interest rates.

Sensing a shift in the economics of the industry, creditors around the world have started questioning the easy money offered to PE firms, which feed off risky types of debt. The prospect of dwindling returns makes buy-out firms reluctant to club together to buy the big companies they covet; banks, meanwhile, are growing wary of offering their own capital as “bridge” finance.

Well, it’s not yet time to sing a requiem to PE boom. But if interest rates keep heading northwards, it could soon be a contagion. PE is inevitably a “feast and famine” business: when one fund can raise a lot of capital, they all can. It helps turn illiquid bank-dominated debt markets into highways for delivering cheap credit. But the key word is “cheap credit”… something that’s drying up fast.

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