Few may know much about the “cov-lite” loans fuelling this year’s merger mania, but investment guru Anthony Bolton put them at the centre of a stark warning to investors as he signalled this week that he is stepping down at Fidelity.
Bolton used his departing speech as fund manager for Fidelity’s flagship Special Situations fund on Monday to warn of a potential stock market crash following a period of stellar growth on the back of recent merger and acquisition activity.
He highlighted what could be the tinder paper for a serious reversal in the market: the “covenant-lite” loans being taken by private equity firms hungry for further acquisitions. Unlike traditional loans these do not include legal covenants that typically allow investors to monitor a lender, and demand repayment or seize control of a company, if that company underperforms.
Bolton said the growing flood of private equity deals, financed by easy lending, has caused an indiscriminate bull run in the market. “I find it difficult to find cheap shares. The low-risk and high-risk shares have gone up together. That spells danger,” he said.
Referring to the growth of cov-lite loans, he added: “It is only a question of when rather than if [things go wrong]. I can’t tell you when it’s coming. I can tell you the pressures are there.”
Bolton has been proved right more times than most, and his concerns about the ease of borrowing will worry many investment experts.
Covenant-lite deals emerged in the US in 2006, but have only been used as the basis for private equity acquisitions in the UK within the past few months. They were used by Apax in its acquisition of Trader Media in March and in the £11bn purchase of Alliance Boots by private equity giant Kohlberg Kravis Roberts (KKR).
The desire of banks to lend money for the huge corporate buyouts has meant private equity firms can often influence the level of rates charged and conditions attached.
Typically, banks carry out a quarterly monitoring of a company’s cash flow to make sure their money is not in any danger. If conditions relating to operating performance are broken, the bank can demand repayment or take control of a business.
But cov-lite loans dispense with certain conditions, so a business could run out of money before a bank has the opportunity to intervene.
These loans have allowed the huge amounts of money being raised by buyout firms to be turned into highly-leveraged takeover war chests. Private Equity Intelligence estimates that £67bn was raised by UK private equity firms alone last year, while £452bn was raised globally.
According to Standard & Poor’s LCD, a division of the credit rating agency, 88 per cent of leveraged loans arranged in Europe last year were private equity-related, almost twice that of 1999.
There are two main worries with this: that these loans have helped fuel an artificial bubble in the stock market, and that there is the potential for more damaging defaults on these loans owing to the lack of intervention and control by the banks.
Tim Cockerill, head of research at Rowan & Company Capital Management, says that the private equity-fuelled acquisition activity across the board has led to an indiscriminate rise in all stocks.
Cockerill believes the FTSE 250 stocks have been particularly driven by private equity money and so are due a correction. “We’re moving more into the mega- cap stocks as we think the market will correct itself elsewhere,” he says.
One investment banker, who did not want to be named, says problems might not be simply related to a turn in the fortunes of the equity market. He says any potential risk of default is exacerbated by the fact that banks will typically try to sell on the opportunity to take a part of the loan to institutional investors such as pension funds.
As such, any loss on a bad loan would not just be felt by the bank’s shareholders but fund holders and pension money could also be hit. He says that many fund managers have a leveraged loan desk but it is impossible to know if exposure to the cov-lite market is significant or not. “In the US, they experienced a bad loan cycle in 1996, but Europe hasn’t really had a market like this before so there is an open wallet policy,” he adds. “We will need one of those loans to go bad before we see which investors are going to be affected.”
Ted Scott, manager of the F&C UK Growth and Income Fund, agrees the creation of a “credit derivatives market”, where these loans are packaged up and sold on, has spread risk of failure across the market.
“The credit market is quite dangerous as we’ve been operating in a very cheap money environment. We don’t really know who is holding a lot of loans at the level below the banks, although it is probably too risky for many funds.”
Scott says there would need to be a major default on a loan to affect investors. He instead sees the private equity interest fade as the market prices in potential takeover levels, which could lead to a natural cooling off. Even so, Scott predicts a more immediate response by the market to recent gains. “The markets have gone up a long way on merger speculation fuelled by the private equity buyers. It is due a correction, and soon.”
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