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Private equity’s looking a little dicey

Bob Moon Jul 11, 2007
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Private equity’s looking a little dicey

Bob Moon Jul 11, 2007
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TEXT OF INTERVIEW

Kai Ryssdal: You can, in today’s world of high finance, find a way to risk your money on just about anything. Whether it might snow in St. Louis on Christmas or whether the Dow might break 14,000 by Thanksgiving. Or a million things more complicated.

In a word, they’re financial instruments called derivatives. They can get pretty specialized. So focused, in fact, that in some cases, they give observers a pretty good idea of which way the market’s going.

Our case in point today is the world of private equity. And how investors are feeling about them being able to pay back all the money they’ve borrowed to do the deals they’ve done. Not so good, is the quick headline. “A withdrawal of liquidity” is what one fund manager called it.

We’ve got Marketplace’s Bob Moon here to help us make sense of it all. Hi, Bob.

Bob Moon: Hello, Kai.

Ryssdal: All right, so help us out here. Why is it that investors are just now starting to worry about whether the companies that are involved in these big private-equity deals that we’ve been seeing might not be able to dig themselves out of debt right now?

Moon: Well Kai, we’ve been talking for quite some time now, you’ll recall, about how much of a glut of investment capital that there’s been. Hundreds of billions of dollars floating around out there from various sources — big pension funds, insurance companies, wealthy individuals. Then you’ve had the big banks throwing even more money on the table. That’s provided the powerful “leverage.” Typically, two-thirds of the cost of these big deals is borrowed money.

Ryssdal: Yeah, it’s almost like money’s sort of growing on trees out there.

Moon: Yeah. That’s a perfect metaphor, actually, if I can borrow on that.

Ryssdal: Sure.

Moon: Seasons change. We could be seeing the first signs that some of the green might be coming off those trees for these big private-equity firms.

Ryssdal: All right, give it up. How so?

Moon: Well, there’s actually this very specialized form of speculating here, wagering on what the likelihood is that a company will be able to repay its debt. There’s an index that tracks something called “credit default swaps,” and it seems to be flashing some warning signals today. These speculators are essentially telling us that they see these big loans that are used in these leveraged buyouts as the riskiest they’ve been in at least nine months.

You have to understand here that there’s been so much investment capital out there that the banks have been offering great terms in providing the financing for these leveraged buyouts. But just as the air came out of the subprime mortgage market, there’s growing concern that these companies are being loaded up with so much debt that they might have trouble paying it back. We’re talking about debt levels in some cases almost 10 times a company’s profits here.

Dartmouth professor Colin Blaydon has been watching the way these private-equity loans have been developing:

Colin Blaydon: The debt that has been put on these companies has been put on with very limited requirements about repayment of capital — they can hold onto it for quite a long time. Even payment of interest — if the company can’t pay the interest in cash, they can pay it with their own stock. That’s dangerous, because it dilutes the equity.

On the other hand, this cuts both ways. It’s precisely because these repayment terms are so light on the companies that Blaydon doesn’t think that we’re headed for a big fall here. Although just yesterday, the debt-rating agency Moody’s issued a report that raises concerns about these companies with higher debt being vulnerable to any economic downturn.

Ryssdal: All right, so find the light at the end of the tunnel here for us. Where is this leading us?

Moon: Well, what does seem to be likely is that now that banks and investors are pulling back, these buyout firms are gonna find it more expensive to borrow, and/or they’re gonna have to agree to less-favorable terms here. And that could put the brakes on some of these deals.

That’s something that professor Blaydon at Dartmouth’s Tuck School of Business told us we should watch out for:

Blaydon: If anything will bring this party that we’ve seen over the last two years to a screeching halt, it would be a dramatic failure along the lines of one of the very big and very prominent deals. That could shake the confidence in this model. So far, it seems to be working pretty well.

But, interestingly enough, Kai, these latest worries circulating the financial community have already fueled some speculation that the big private-equity firm Cerberus might have trouble lining up financing for the deal it made to buy Chrysler.

A spokesman for DaimlerChrysler in Germany says there’s been no delay from their side. Cerberus is insisting today that deal will close as planned in the third quarter of this year. But DaimlerChrysler’s stock did loose 1.6 percent on Germany’s DAX today. Although one analyst suggested today that that probably had less to do with the chance of this deal falling through, than it did with the falling value of the dollar.

Ryssdal: A point which, as it happens, we’ll be getting to in about, I don’t know, 30 seconds or so. Marketplace’s senior business correspondent Bob Moon. Thank you, Bob.

Moon: Thanks, Kai.

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