Private equity funds have troubles of their own

If recent stock market rises give the impression the worst of the financial crisis may be over, get ready for more possible shocks.

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If recent stock market rises give the impression the worst of the financial crisis may be over, get ready for more possible shocks. This time, however, the potential for a fresh crisis comes from the private equity world. Just like hedge funds, private equity epitomised the excesses of the boom years. And the implications for the Gulf can be serious because private equity funds were popular for a while among some investors and institutions in the region.

In essence, private equity firms buy companies using high levels of debt. Sometimes, the executives would also use the borrowed money to pay themselves hefty bonuses. Some may have taken profits from the companies they bought to repay the debt. That is good. Others might also have injected some of the borrowed money into the purchased firms. That can be good, too. The point is, it works in different ways, except for one thing: in all cases, it involves borrowed money loaded on to the leveraged firms that are acquired. Some leveraged buyouts carry debt of 20 times the firm's annual profits, which is not a healthy sign even in good times.

For investors in the private equity funds, there is another issue. If they, too, had borrowed heavily to participate in the funds, they would find it difficult to liquidate assets in a distressed market to service their debt. But if they didn't, there is at least one less worry. The more pressing question, however, is this: how liquid and safe are private equity funds at this time? According to The Guardian, almost a third of the UK's mid-market firms that were acquired by private equity funds in leveraged buyouts are expected to fail, or to need restructuring as a consequence of the economic crisis. A number of property companies could fail to meet their loan-to-value covenants, under which lenders set a minimum value for the acquisition. In the Gulf, although it would apply elsewhere as well, this might spell trouble for property-loaded private equity funds. And in other sectors, covenants linked to the underlying performance of the business could be breached.

According to The Daily Telegraph, among the names in the distressed debt market that investors have been watching for months is Foxtons, the upmarket property agency owned by the private equity company BC Partners, advised by Rothschild, and whose creditors were helped by another restructuring specialist private equity firm, Close Brothers. The debt is mostly still in the hands of its original lenders, Mizuho and Bank of America. Creditors are already negotiating a debt restructuring at Four Seasons, the UK's second-largest home-care operator, which in January won a third suspension of its debt payments.

Britain is expected to have more corporate failures than any other European country, as it was a favourite site of private equity leveraged buyouts in recent years. As victims of an over-leveraged balance sheet or a deteriorating economy, a significant number of companies will not avoid the effects of the credit squeeze. There could be a silver lining, though, for some Gulf investors in private equity funds. They kept clear of funds that were not invested according to Islamic financing principles. This saved them from investing in funds caught up in the bidding game for assets - the ones that failed to look at company fundamentals such as future earnings, for example. Private equity funds that have been more prudent, however, will most probably survive, and might even manage to pick up some bargains along the way.

Dr Mohamed A Ramady is a former banker and visiting associate professor in the finance and economics department of King Fahd University of Petroleum and Minerals in Dhahran, Saudi Arabia