Repricing of debt and equity issues

In the current market, not a day goes by without news that the financing of another high-profile acquisition or buyout has run into trouble. The collapse of the US sub-prime mortgage market has wreaked havoc in the leveraged loans sector, as banks such as Citigroup, RBS and JPMorgan have suddenly found themselves stuck with private equity-related debt sitting on their balance sheets as a result of underwritten but as yet unsyndicated loans.

The fallout in sub-primes has served as a wake-up call to the wider credit market which has provided cheap money to consumers and corporations in the past several years. Investors evaluated the extent of the fallout from US mortgages and watched to see which banks and hedge funds had been left exposed, so they have also been monitoring the leverage finance market. As a result banks which lend to corporations or private equity firms are also having difficulty passing on the risk with syndicated loans and are forced to sell to investors at a loss or keep the credit on their books Hundreds of billions of dollars of private equity-related debt are putting a strain on the finances of some of the investment world’s biggest institutions as the buyout industry has all but ground to a halt, paralysed by turmoil in the market for credit. There is a widespread reluctance to make loans to more-risky home buyers and companies and to hold securities backed by such loans.

HIGHER SPREADS AND RISK REPRICING

Such is the chaos in the credit markets that spreads on high-grade corporate bonds have also widened, indicating that even the bonds of safe-haven corporations are seen as higher risk. Several corporate bond issues have been put on hold as companies decide it is safer to sit on the sidelines and wait for the markets to calm down before dipping their toe in. The banks’ problem is that the investors who used to queue up to buy the high-risk loans – the so-called CLOs and CDOs – have now all but disappeared. Those that are prepared to buy will do so only in the secondary market, where the debt has been syndicated and is trading way below par, representing huge discounts for any investor brave enough to snap it up. Compounding the problem, the number of collateralised loan obligations (CLOs) – even if they were prepared to buy – has also fallen dramatically because it is the banks who create the packages of CLO debt and sell them on to fund managers to run. The result is a vicious circle. As the banks have stopped lending, the number of CLOs has fallen and with it, the number of investors available to buy the bank debt has tumbled, too. The only way that the debt can get sold is if banks sell it at a huge discount.One might hope that the market will calm down soon. The wider economy, after all, is in good health. But that will not happen overnight. Some of the syndicated loan deals will need repricing only, but some will also need restructuring by the banks in particular as spreads have widened and so senior debt has become more expensive. The worst-case scenario for the banks is underwritten deals that need repricing and restructuring and where the underlying company is seen as a risk. Investors may still refuse to get involved.

HIGHER COST OF CAPITAL

In general in our view changes in the costs of capital at the debt structure level have to increase for the time being and this should translate into different pricing at the equity level. The repricing of risk and volatility threaten to end the easy financing of corporate takeover deals, a key factor behind a four-year rally in equities. On the other side treasuries are benefiting from heightened risk aversion as corporate bond risk has risen in Japan, Europe and North America.

Drs. Alphons P. Ranner is founder and director of Sovereign BV financial consultancy. His background includes many years of experience in strategic and financial management and consulting.

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