[A-List] Private equity vs. hedge funds

["Michael Keaney" <michael011@xxxxxxxxxxx>]

Private equity tightens grip in debt markets
By Gillian Tett
Financial Times: March 16 2007

In recent years, the ambitions of the private equity world have never
ceased to amaze. Now, however, new antics are emerging in the debt world
which are leaving even seasoned bankers surprised.

In recent weeks, a number of private equity groups ? or ?sponsors? as
they tend to be known in the debt markets ? have asked their banks to
raise finance for leveraged buy-outs using instruments, such as loans,
which carry legal clauses that essentially prevent creditors from
selling debt to hedge funds.

Some funds have even apparently produced a blacklist of hedge fund names
they do not like, and attempted to create legal clauses that shut these
undesirables out. It is the financial equivalent of being blackballed.

?You get sponsors who say they don?t want such-and-such a fund getting
this debt ? and demand ways to keep them out,? the head of debt
syndication at one bulge-bracket bank in London told me.

He said he had recently seen a sharp increase in such requests, some of
which had been fulfilled.

It is not difficult to understand why sponsors would act like this. The
last time the private equity world was hit by a downturn in the credit
cycle, many of the loans that underpinned these deals were in the hands
of banks, particularly in Europe.

But this decade a revolution has occurred in Europe. According to
Standard & Poor?s, non-banks, such as hedge funds, now account for about
half of the primary leveraged loan market, and the figure can be nearer
80 per cent in some deals.

Meanwhile, in the subsequent secondary-market trading of this debt,
funds are even more dominant, since the first thing any bank does when a
loan becomes troubled is sell it to a fund.

As a result, in the next credit crunch it will not be the gentlemanly
bankers who are holding the LBO loans. Instead, the new creditors are
participants who are ruthlessly focused on profits and aggressive about
grabbing them however they can. They look rather similar to many of the
sponsors themselves. No wonder the private equity world is nervous;
piranhas are usually good at smelling each other.

Whether sponsors will succeed in shutting hedge funds out of LBO debt is
another matter. Most investment bankers are reluctant to let sponsors
insert legal language into debt deals which restrict the subsequent sale
of loans. That is partly because such clauses make it harder to
syndicate these deals, but also because these controls could potentially
hurt banks themselves. If it becomes harder for a bank to sell loans to
a fund if trouble hits, banks could be left with toxic problems on their
own book.

Even if a sponsor does bully a bank into inserting sales controls, it is
unclear how much force these clauses will carry if a downturn hits. Most
lawyers claim that any restrictions on the sale of debt become void if a
company defaults.

Nevertheless, rumours are now rife in London that deals have recently
been created with these restrictive clauses, albeit furtively. More
visibly, many loans now include ?yank the bank? legal clauses, which
effectively allow an issuer to remove any member of a bank syndicate it
dislikes, such as a hedge fund threatening to block a restructuring
plan. Similarly, one law firm is preparing a contract which removes the
need for an issuer to receive unanimous creditor approval before
changing a loan?s terms.

The trend raises two points. First, it indicates, once again, the
extraordinary degree of power that the private equity world has recently
been able to exercise in the debt markets. For investors have been so
hungry for leveraged assets, they have not only been buying loans at
ridiculously low prices, but on increasingly disadvantageous terms. Thus
far, there is no sign of an end to this trend in Europe, irrespective of
the recent turmoil in the US subprime sector.

Second, if ? or when ? the credit cycle does turn in the leveraged
finance world, it will pit private equity funds against hedge funds to a
degree rarely seen before. That would make compelling viewing, since it
could be a nasty battle.

No wonder the sponsors are proactively arming with every legal weapon
they can find. No wonder Goldman Sachs recently announced that its
European restructuring business is to be co-headed by a lawyer, for the
first time.

When the piranhas do start fighting for real in the financial fish-tank,
the winners from the bloodletting are likely to be the lawyers.


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