Some sunny day...

The last six months of 2008 witnessed a remarkable, if not surprising, collapse in the banking sector, which culminated in several headline-grabbing bail-outs of major institutions. The most notable of these from a private equity perspective occurred in the UK, where the Government agreed to pump a total of £37m of public money into Royal Bank of Scotland, Lloyds TSB and HBOS (with these latter two dependent on the completion of their proposed merger); three of the top five lenders to buyout transactions in the country. State intervention was not confined to the UK: the Dutch government wholly acquired the Netherlands operations of Fortis; the Belgian and Luxembourg governments obtained a blocking minority stake in BNP Paribas (which acquired the Belgian and Luxembourg operations of Fortis); and the French government also injected capital into BNP, as well as Crédit Agricole and Société Générale, as part of a €10.5bn rescue package. In total, eight of the most prolific ten buyout lenders across Europe are now effectively part-nationalised (see chart).

This has given rise to concerns from within the buyout community surrounding the availability of debt financing over the coming years. Many suggest that, with Governments emphasising the need to re-start lending to homeowners and small businesses and regulators piling pressure on banks to 'deleverage' their balance sheets, these intuitions will continue to keep their doors shut even when the debt markets recover. "With pressure being placed on banks by their new owners to use what scarce capital there is to support SME's and homeowners, it is likely that funding for mid and large cap buy-outs will likely dry up completely," comments Philip Shapiro, managing partner of Synova Capital. Indeed, in the UK BVCA chief Simon Walker is said to have held several meetings in Whitehall in an effort to persuade the Government of the need to maintain lending to its members, which have been a driving force in UK M&A activity in recent years.

Public interest
Much of the concern in relation to this issue centres around the perception of private equity and the influence this is likely to have on the attitude of Government. The asset class has been plagued in recent years by negative press attention, which has led to a broadly negative perception amongst a public that has been under-educated as to its benefits and that now finds itself as a reluctant indirect shareholder in the banking sector. "Banks are unlikely to win any points or favour publically by opening up to private equity," confirms Jeremy Furniss, partner at Livingstone Partners. Furthermore, given that even the most conservative industry pro is predicting a significant number of portfolio company bankruptcies in 2009, it is possible that private equity will once again find itself in the media spotlight over its use of debt and the strain it puts on businesses, which will only serve to compound the negative stereotypes.

However there is an emerging view that these concerns are unfounded, an opinion supported by a consistent message from the clearing banks that acquisition financing remains a core component of their corporate activity. "It's a case of survival for the corporate divisions of these banks; if they want to retain their position in the market they will need to keep lending to private equity," explains Andrew Gray, senior partner at Graphite Capital. In terms of the potential for the asset class to once again become politicised in the wake of a spate of insolvencies, Gray suggests that this is unlikely, as the underlying motive for the press to target the industry has been eroded. "18 months ago media attention was, perhaps not unfairly, focused on the top end of the market as a result of the large sums of money that were being made. Now that most of the equity in these deals has been wiped out that story just isn't there," he says.

The cost of capital
Though the potential problem of Government intervention directly affecting banks' lending policy as a result of public scrutiny is currently a point of contention, there is a general consensus that the ramifications of the bailouts will have other long term influences on the sector. Andrew Lynn, director in Hawkpoint's debt advisory practice, argues that the capital raising initiatives instigated at the end of the year to shore up depleted balance sheets, which saw large portions of equity sacrificed as a result of the poor share prices, will have to paid back with interest and this has effectively increased the cost of capital for banks. This is perhaps even more prevalent for the institutions that shunned the Government offer and refinanced privately, such as Barclays, which raised around £7.3bn from investors in the Middle East. Around £3bn of this was raised in the form of so-called Reserve Capital Instruments, paid back over 10 years at 14% interest - the highest rate being charged for bank capital and significantly higher than the 11-12% being charged by the Government, which is also paid back over a shorter time period.

In addition, banks are now grappling with increased pressure from regulators in relation to the Basel II accord, which came into effect across Europe as part of the Capital Requirements Directive in early 2008. The new regulations stipulate the amount of capital that banks must hold in reserve to offset the potential risks from various lending practices, the net result of which will be an increase in the amount of money that will be tied up on balance sheets in relation to any given transaction. With banks already struggling with depleted capital reserves, and with many of their existing loans expected to default in the coming months, it is likely to be some time before these problems are resolved. "The increased cost of cash at the moment, coupled with Basel II, has created a set of commercial pressures that make lending less likely going forward," Lynn explains.

Trouble at the top
Despite these concerns, most do expect something of a return of lending to the small- and mid-market in the early part of the year following a ceasing up at the end of 2008. "The market died in the latter part of the year because banks were suffering with serious liquidity issues and, with many having made their budgets in a comparatively busy first six months, they had no literal incentive to target new deals," Gray comments, "they will therefore start anew in the New Year." It is unrealistic, though, to expect any recovery to be anything other than slow and cautious, with deals being financed on a very selective basis. "The fundamentals of financing are going to come back to the fore and credit decisions are going to be very black and white in the coming 12 months," says Lynn.

In contrast, with the market for syndication looking increasingly unlikely to make any return and the cost of putting together a large debt package (not to mention the risks) extremely unattractive in the current climate, the top end of the market is almost universally expected to remain inactive. "I could foresee a deal worth a couple of hundred million getting done if a big club of lenders could be put together, but anything more is a struggle unless the large banks are prepared to dip their toes into underwriting again." Lynn suggests. With this almost certainly off the cards in 2009 and perhaps beyond, large-cap buyout houses with substantial pools of capital will be forced to look for alternative methods of financing big deals or face the prospect of downsizing. "Private equity funds are going to have to look beyond their historic leveraged finance banking relationships and develop relationships with better capitalised overseas banks, specialist institutional debt providers and asset backed lenders if appropriate," claims Shapiro.

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