Heavy borrowing by private equity groups to fund leveraged buyouts is leaving many of the target companies that they acquire in a fragile financial condition, the International Monetary Fund told investors and regulators yesterday, according to the UK’s Times Online.
As new figures from Private Equity Intelligence showed the sector awash with capital, with buyout groups raising a record $81 billion in the first quarter, 56% more than a year earlier, the IMF voiced concerns about its debt level.
Leveraged buyouts by private equity funds using a very high degree of leveraging have significantly weakened the credit quality of the targeted companies, Gerd Hausler, head of the IMFs International Capital Markets department, said.
In its twice-yearly assessment of risks to global financial stability, the IMF singled out a shift in the behaviour of private equity funds that increasingly has seen them load up companies that they buy out with debt in order to extract early dividends for their investors.
Recently, acquirers have adopted the practice of significantly leveraging the balance sheets of the companies they have just acquired so as to pay high dividends to themselves right away, the IMF noted.
This is in contrast with past practices, according to which acquirers spent about five years, if not more, improving the profitability of the acquired company before doing an initial public offering or a trade sale to realise their investments.
The IMFs report highlighted figures that showed that the level of debt used to fund private equity deals has soared from three to four times underlying earnings to a typical level of between six and eight times.
The concern from the IMF came as it sounded a more general warning over a turn in the corporate credit cycle, which has seen significant numbers of companies move from strengthening balance sheets and piling up cash to stepping up their borrowing.
Many corporations have begun to releverage by increasing dividend payments, buying back their own shares, and engaging in merger and acquisition activity, it noted.
The IMF believes that corporate finances remain healthy overall.
However, it cautioned that an unexpected worsening in the financial condition of a very large name in the fast growing market for credit derivatives could trigger financial market turmoil.
This could include a chain reaction in which pressure on hedge funds to sell assets led to wider turbulence, it said.
In contrast to the IMFs anxieties, the latest snapshot of global fund managers views from Merrill Lynch yesterday showed that they still regard companies as under-leveraged and in need of greater capital investment activity.
In yesterdays report the IMF highlighted other potential threats to financial markets, including from a possible correction in the booming American housing market.
However, it played down any immediate dangers posed by the global imbalances symptomised by the vast American current account deficit and from the impact of rising interest rates in Europe, the United States and Japan.