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The recent credit upheaval has already impacted on deals, but will it necessarily have an adverse effect on the private equity industry?

What a difference a few weeks can make in debt advisory. In the leveraged buy-out market talk of covenant-lite loans, PIK notes and restrictions on debt trading has dried up as quickly as much of the credit itself. It is generally perceived that private equity houses will be the losers here, but is this true and what should equity sponsors be doing if the credit cycle has indeed turned?

On new deals the market – where there is one - has reverted to terms seen 18 months ago. Some deals that completed have failed to syndicate, sometimes with serious consequences for shareholders, as demonstrated by Esporta, where administrators were called in during August.

From an optimistic viewpoint, reduced competition will allow financial buyers to acquire assets cheaply, for instance exploiting existing stakeholders’ distress by taking control themselves through the debt. Several houses have set up teams with precisely this remit, including 3i and Alchemy.

In many existing deals the sponsors have already taken out hefty dividends funded by refinancings on what now look like very attractive terms – if highly leveraged. Therefore the sponsors’ downside may have been mitigated but future returns on some existing deals could be jeopardised unless the sponsors tread carefully.

Sponsors need to understand who holds the debt (and review closely the debt trading provisions in the documents) as the original banks may have sold down, either openly, or discreetly via sub participation to a range of alternative institutions – and the debt may continue to trade frequently. Workout bankers and distressed debt investors will replace relationship bankers at the table, bringing with them very different agendas. It is essential for the sponsor to understand – and have a strategy for – this changing dynamic.

If the credit market has turned, sponsors will be left with some hard decisions on under-performing investments. Banks may look to them to inject new equity, while distressed debt investors may look to take control. Sponsors will need to be selective as to when to hand over the keys and when to provide further support – and if so on what conditions.

However, in this environment there will also be opportunities. In existing deals sponsors might be able to buy back debt (possibly undisclosed to minimise the price) to de-gear, particularly if hedge fund debt-holders need to raise cash to reduce their own gearing; alternatively sponsors should be able to demand a greater debt write-off in exchange for providing new equity where a company needs new money.

In new deals reduced competition and tighter credit should lead to lower prices; and, taking a leaf out of the hedge funds’ book, investors might adopt a ‘loan-to-own’ strategy to acquire stressed assets through the back door.

As ever the key will be to ensure value for money, and a sponsor willing to invest, or inject new funds into existing investments, in the current market should not underestimate its negotiating position.

Peter Collini is managing director of corporate finance firm Riverhill Partners.

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