This market doesn’t feel to me like one that’s teetering on the edge of a crash. For all the doom and gloom about the subprime mortgage meltdown in the US, all I see is evidence of remarkable bullishness everywhere. After a slow start to the year, European merger and acquisition volumes are back up to last year’s levels. It seems that almost half the FTSE 100 is the subject of private-equity takeover speculation: Sainsbury’s, Boots, Whitbread, Pearson, Unilever and so on. Even the UK’s once-timid bosses seem to have rediscovered their animal spirits. Barclays and Vodafone are both pursuing big foreign deals. No sign of a lack of confidence there.
Debt markets seem unconcerned by subprime fiasco
Meanwhile, the debt markets seem even less worried by the subprime fiasco. This week’s eye-popping innovation is “covenant-lite” loans, which are just like ordinary loans, except that the borrower no longer has to promise not to sink ever further into debt or meet certain financial conditions. When these appeared in the US earlier this year, few thought Europe’s more cautious lenders would stand for it. But stand for it they have, with the first covenant-lite loan agreed this week for Dutch publisher VNU. Other borrowers have taken to “re-pricing” their loans, which basically means refusing to pay the bank the agreed interest rate in favour of something more to their liking. Try doing that with your mortgage provider and see where it gets you. But banks are so desperate for private-equity business, they will put up with it.
At some point, all this lax lending is bound to lead to trouble. But I don’t think we’re there yet. As one hedge-fund manager put it to me this week, there are four stages to the credit cycle. The first stage is when an economy is emerging from a downturn and a rising tide lifts all boats. The second stage is when everybody can get easy access to credit and defaults are low. In the third stage, credit remains plentiful, but the first signs of distress appear among those who have borrowed too much. The final stage is the downturn and a possible recession. In this fund manager’s view, we’re just entering the third stage. Credit still remains easily available and defaults are low, but we’re likely to see more signs of trouble.
Given this cycle only began in 2003 and most credit cycles are ten years, he thinks this stage could continue for some time.
What could spook the markets?
What could trip this scenario up? Well, there’s always the possibility a big firm could get into trouble and thus spook the markets, just as the downgrade of General Motors’ bonds did two years ago. That could cause credit conditions to tighten for everybody. And at some point, it’s possible that rising interest rates will slow the world economy, pushing highly indebted firms over the edge. Perhaps the biggest risk is that rising defaults will cause problems for a new kind of lender called Collateralised Loan Obligations (CLOs): these package up large numbers of loans and parcel them out to investors in the form of bonds. If companies started defaulting, CLOs might be forced to start selling their underlying loans all at the same time, to maintain their credit-ratings. That could create a risk to the entire financial system. But that’s a lot of big “ifs” – and there’s not much sign of it happening yet.
How private-equity took over
I’ve no idea whether all this frenzied speculation about private-equity bids for half the FTSE 100 will come to anything. My guess is most of it won’t. The odds are still fairly heavily stacked in favour of public companies to see off private equity if the board doesn’t want to play ball. Private equity can’t make hostile bids because the banks won’t lend them the money unless they’ve seen the books, so any deal has to be agreed. That means that many of the companies that could most benefit from being taken private never do because their management know they will lose their jobs – which makes them more inclined to dig in their heels.
Even so, all this current activity does raise an interesting question: what is the future for public companies? I’ve never quite understood the sentimental attachment to public firms. Unions like them because they know public shareholders are weak, so it is easier to bully management and boards. But that is a good reason why investors should be wary. Besides, public-company bosses have to spend huge amounts of time dealing with shareholders – time that could be spent running the business. One FTSE 100 boss told me this week that he spends at least 20% of his time on investor relations. That means he’s only working four days a week at his real job.
When you factor in other advantages enjoyed by private equity, including the use of leverage and the freedom from the tyranny of quarterly results, you wonder why any company given the option would choose to remain public. Historically, firms had no choice because the stockmarket was the only available pool of capital. But that is no longer the case. The world has been experimenting with different forms of corporate organisation for several hundred years now. It might take a while for the private-equity revolution to run its course. But revolution it surely is.
Simon Nixon is executive editor of Breakingviews.com