What private equity and first-time buyers have in common

Record bankruptcy levels show just how badly overstretched the British consumer is. But it’s not just consumers who are leaving themselves exposed to changes in the economic climate, says John Stepek.

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We've heard a great deal recently about the UK's debt burden, and how record bankruptcy levels show just how badly overstretched the British consumer is.

But it's not just consumers who are leaving themselves exposed to changes in the economic climate.

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Britain's financial sector watchdog, the Financial Services Authority, has just published a report into the private equity sector. The FSA is concerned at both the amount of money at the disposal of private equity firms, and the amount of borrowing they pile on top to push their deals through.

Now the world of private equity, where hedge funds and investment banks back bids worth billions of pounds for huge companies might seem a world away from the UK consumer and their £100,000 mortgages.

But debt is debt, and in many ways the problems facing the two are very similar...

The FSA has said that the collapse of a large private equity-backed company is "inevitable," reports The Times.

The FSA's not the only one predicting trouble ahead. Credit ratings agency Standard & Poor said last month that the company default rate was at its lowest in nearly 25 years - but it reckons that will pick up between now and the end of 2007. And certainly, when a trend hits a historic low, it's usually a fair bet to say it will be rising at some point in the near future.

So what kind of impact would that have on all those lending to private equity? A report by the watchdog found that banks' exposure to leveraged buy-out deals (that's basically where a private equity firm borrows money to buy another company) stood at £68bn in the year to June - up nearly a fifth on the previous year.

Nowadays, of course, all the talk is of how sophisticated new financial instruments allow risk to be spread throughout the financial system, so that if one company goes down, there is a small but non-catastrophic hit to several creditors, rather than a killer blow to one. But this creates its own problems.

Hector Sants, the FSAs head of wholesale markets, said:: "If we were to have a failure of a leveraged private-equity backed company it would be quite difficult to put a small number of owners of that risk around a table the flipside of increased risk dispersion is increased difficulty in managing a failure." In other words, sorting out who's actually exposed to a default, and then getting them all to co-operate on a solution, such as a debt restructuring rescue package, could prove much more difficult now than ever before.

And as Anthony Hilton says in London's Evening Standard, the chance of a default is raised by the fact that much of the debt is structured in a somewhat optimistic manner. "It is cheap in the early years but becomes much more expensive later on, the theory being that the company will have grown in the meantime and will be able to meet the additional burden when it comes on stream."

This is a bit like a young couple taking out an interest-only mortgage, with the full intention of converting to repayment in two years' time, when they're earning more. The trouble is, there are a whole raft of assumptions behind this reasoning. There's the assumption that they will perform well enough to hold down their jobs, which in turn assumes that the company stays in good financial health, which in turn assumes that the economic position in the UK remains reasonably benign.

Those are exactly the assumptions being made by both borrowers and lenders in these private equity deals, only on a much bigger scale. But if things turn sour - as a result, say, of a massive slowdown or even recession in the US - then all those assumptions will be turned on their heads. And its exactly then, just when the borrowers can least afford it, that some of their more flighty lenders will want their money back.

As Hilton says, a recent report by Dresdner Kleinwort points out that many of those providing financing for these deals are hedge funds. If interest rates do rise to uncomfortable levels, they are much more likely to cut and run than the typical bank. If the cycle turns, private equity groups are also likely to find "that the pool of liquidity which enabled the company to gear up so heavily in the first place may no longer be available. Liquidity has risen steadily and strongly over the last three years but investors and sponsors may find that it takes a little less time for it to evaporate."

When high street banks decide they've been too lenient with credit, they yank it fast - witness the sudden reversal in credit card lending growth this year. Those who are backing private equity deals will be no different.

And with interest rates rising across the globe, tighter times in the credit cycle may just be around the corner - for both indebted consumers and indebted corporations.

Turning to the stock markets...

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Blue chip stocks hit a new five-and-half year high in London yesterday. A strong mining sector, boosted by the highest price of gold futures in two months, and a rally on Wall Street spurred the FTSE 100 to a close of 6,224, a 76-point gain. Miners Antofagasta, Anglo American and Xstrata were the day's biggest risers. For a full market report, see: London market close

Across the Channel, the Paris CAC-40 closed 66 points higher, at 5,402. In Frankfurt, the DAX-30 ended the day 89 points higher, at 6,330, with insurer Munich Re the biggest riser of the day on expectations of strong Q3 results, to be announced today.

On Wall Street, M&A activity and encouraging remarks from Fed official Michael Moskow saw stocks close higher. The Dow Jones ended its losing streak to close at 12,105, a 119-point gain. The Nasdaq was 35 points higher, at 2,365, and the S&P 500 ended the day 15 points higher, at 1,319.

In Asia, the Nikkei rose 28 points to close at 16,393 today.

The price of crude oil rose to a one-week high yesterday and was trading at $60.14 this morning. In London, Brent spot was at £57.88.

Spot gold rose to a two-month high of $629.40, but had slipped back to $624.90 today.

And in London this morning, clothing retailer Marks & Spencer reported its highest first-half profit in a decade. Net income has risen to £281.3m from £212.6m last year as a result of new clothing designs for the womenswear range and a successful advertising campaign starring Erin O'Connor.

And our two recommended articles for today...

Are the markets really always right?

- There are certain market indicators investors always trust - but what happens when these come into conflict with one another? The key indicators may be signalling bad news, but 'good time' asset classes continue to thrive. So what's the logic? asks Niels C. Jensen of Absolute Return Partners. To find out whether or not it's time to brace yourself for a recession, read: Are the markets really always right?

Hey big spenders - it's time to get real

- Egged on by fashion magazines and their 'must-have' designer handbags, and financed by a glut of available credit, we have become a nation of debt junkies, says Merryn Somerset-Webb. With bankruptcy on the rise - and the average age of bankrupts falling - it's time to face up to the consequences. For more on the dangers of debt, from designer credit card sprees to mortgages five times the borrower's salary, see: Hey big spenders - it's time to get real

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.