Facing the fear

Long deemed insulated from the worst of the economic woes, private equity is now in the eye of the storm. Notably industry giant 3i has recently had to reconfigure its fund portfolio interests to raise money to pay down debt; selling off £61m worth of shares in 3i Infrastructure Plc and buying back interests in its cash-rich Quoted Private Equity ('QPE') Fund.

Such problems will continue and grow in prominence. One of the key contributory factors is the operational issue of actually calculating the value of fund investments and the effect that has on the loan-to-value and debt-to-equity ratios. The loan-to-value ratio is the ratio of debt which a manager carries compared with the value of its underlying investments. Similarly the debt-to-equity is the ratio of debt compared with value of its shareholding/equity investment.

Values of investments and equity holdings have fallen significantly over the last twelve to eighteen months, and this has increased the possibility of actual or imminent breaches of ratios. These ratios often form part of a manager's contractual covenants with its bank under its facility and therefore breaches jeopardise the loan facilities and operations of many managers. This is not only the case for managers who increased their leverage whilst debt was 'cheap' in the market. Many prudent managers, who have traditionally maintained low ratios and have used equity raisings to pay down debt, are also being caught out by the fall in values.

So far, lenders have been sympathetic to fund managers in other asset classes who find themselves in difficulty, and there have been a number of 'waivers' put in place for covenant breaches. There is no reason why private equity fund managers should be dealt with any differently, provided they are open and timely in informing their lenders of any potential breach. However, if valuations continue to fall it is only a matter of time before banks become more forceful in their actions.

Other than cutting deals with the lender, the same solutions are available to private equity houses as for other fund managers. This might include refinancing with their existing or a new lender (albeit at significantly higher margins); raising new funds by selling interests (as 3i has done); raising cash through a rights issue or cutting distributions to their own investors; or a combination of these.

How private equity houses deal with their debt will therefore be a major area of concern for them and their own investors (and their lawyers). It is only a matter of time before the relatively benign stance that banks have taken in relation to this looming crisis changes.

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