There is little doubt as to the role expanding credit has played in bringing about the current recession. An increasing number of economists believe this recession is the start of a long-term deleveraging of the global economy. They are not without reason: US credit market debt as a percentage of GDP currently stands at 350%. The only other significant rise historically was during the Great Depression. Whether we are on the cusp of a long-term deleveraging of the global economy is still arguable, but a few early signs in US and Europe show that indeed this may be the case: greater regulation of the OTC derivatives market, as indicated by Tim Geithner recently, a potential reinstatement of Glass Steagall act in the US as well as a general aversion to over-leveraged companies, a so-called ‘flight-to-quality’ by the investing public are just some of the signs.
Looking at the data reveals that credit in the US economy has been expanding since the late 1970s, when the world was coming out of the oil crisis. The 1980s saw the coming of age of financial engineering, when the gaining popularity of Leverage Buyouts (LBOs) by early Private Equity giants like KKR ushered in an array of structured finance products and securitization instruments. With a temporary hiatus in the credit market during the late 1980s, caused by the collapse of the junk bond markets, the credit markets rebounded during the dizzying 1990s, with hedge funds sprouting all sorts of new derivative instruments like interest swaps, credit derivatives, even weather derivatives (instruments that essentially bet on the weather).
The existence of a healthy credit market was one of the key ingredients driving large buyout firms. The credit market is where the big private equity firms go to raise debt for acquisitions, debt that would largely sit in the acquired company post-acquisition. In recent years, buyout giants like the Blackstone Group, TPG and Oak Tree have been able to raise huge amounts of debt from banks, pension funds and hedge funds.
So what does a scenario of long-term deleveraging mean for the private equity industry? Well, for starters, it is definitely going to be more difficult to raise financing. At the same time, a large number of deals will not be as profitable if they are funded with more equity. In such an environment, the right strategy for such companies would be to look for opportunities for value addition, not value extraction. This means investing growth capital instead of buyouts. There is still a lot of value to be added by PEs in such situations, especially those who have a clear focus, right linkages and financial muscle. These companies can provide much-needed capital for expansion, unlock value for shareholders and bring about proper risk management and corporate governance. In the ‘steady-state’ post-deleveraging scenario, valuations will settle at lower levels, allowing PE firms to make their required returns.