Jump in private equity deals puts corporate balance sheets at risk

The UK’s Bank of England has warned that a sharp jump in borrowing linked to private equity deals has left corporations at increasing risk of defaulting on loan commitments.

A wave of leveraged buyout (LBO) activity in the UK, which has recently seen takeovers of BAA, the airports operator, and Associated British Ports, the ports group, has raised the average annual default probability of UK companies.

Furthermore, the activities of aggressive private equity firms is having the knock-on effect of tempting companies into taking on more debt to resist takeovers, according to the Bank of England’s twice-yearly Financial Stability Report.

“The direct impact of LBO transactions in 2004 and 2005 may have been to increase the average annual default probability of UK companies by about 0.2 percentage points," notes the report, which was published yesterday.

LBO purchase prices have risen to record multiples of earnings with competition between lenders resulting in a "continued relaxation of loan covenants", the report adds.

The buoyancy of the global LBO market was underlined by a research note published by Goldman Sachs this week explaining that LBO activity in Europe was on course for another strong year. “Following a spectacular 2005, when European LBO volumes almost doubled with respect to 2004, annualised 1H06 figures show that LBO activity remains on track to reach similar levels,” says the bank.

Meanwhile, Société Générale yesterday announced plans to expand its acquisition finance business into the Asia-Pacific region.

The Bank of England’s report cites research by rating agency Standard & Poor’s, which estimates that the debt taken on by a typical European LBO rose to more than eight times earnings in 2005, up from seven times in 2004. However, George Buckley, an economist at Deutsche Bank, says high debt levels in the UK corporate sector should be expected in the current benign interest rate environment. “Gross debt levels as a proportion of gross operating profits have increased rapidly since 1997," he says. "The only real threat to this appears to be from global commodity prices which pose an inflationary risk that may result in the Bank having to tighten interest rates.”

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