Why debt costs could burst private equity bubble

When investments constantly hit the headlines, it's often a sign that a bubble is about to burst. So the fact that private equity is all over the front pages suggests that the only way from here is down.

Enormous amounts of money are sloshing around the industry. Private equity buyouts account for one in three of all business purchases, and, sales-wise, they account for many more, says Heather Connon in The Observer. The top five investment houses have a £38bn war chest that has to be spent by 2010 and sums like that mean almost any target even the likes of Vodafone, BT, Unilever and M&S could be in play.

But the mergers and acquisitions market is looking increasingly unstable, says Bryce Elder in The Times: "Chief executives are making decisions based not on financial logic but on unshakeable opinion of their own brilliance". The deals they cut are increasingly debt-laden: the average one involves six times as much debt as earnings, up from 5.5 in 2005, Fitch Ratings reports. That's fine while debt's cheap, but as Permira's Charles Sherwood tells Connon, if interest rates rise, then assets will have to be re-priced, which may scare investors away from new deals.

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And higher rates could also clobber share-holders in debt-loaded firms that have been refloated by private equity buyers. Debenhams was taken private in 2003 by CVC, Texas Pacific and Merrill Lynch in a £1.8bn deal, of which £130m was reportedly debt. It was refloated in May with a £2.8bn valuation, more than 50% of which was debt. The firm, says Elder, is now "not much more than a gamble that consumers will keep spending".