Trouble on the road ahead for the buyouts that borrowed to the hilt

Europe's leveraged buyout industry is booming. A host of private equity firms, such as Cinven, KKR, Permira and Apax, completed a record £77.3bn worth of buyouts in Europe last year - the highest ever figure - according to analysts at Dealogic.

Europe's leveraged buyout industry is booming. A host of private equity firms, such as Cinven, KKR, Permira and Apax, completed a record £77.3bn worth of buyouts in Europe last year - the highest ever figure - according to analysts at Dealogic.

Yet the private equity deals now being done in Europe have a darker side. Talk of a buyout bubble is growing among investment bankers, debt rating agencies and even some private equity houses. This chatter has been sparked by the vast sums of debt with which private equity firms are now saddling their companies, especially in the mid- to large-cap sector.

Debt levels have soared so high that experts say some of today's overleveraged buyouts will default. "We are very worried about the huge levels of debt being applied to some buyouts in Europe today," says Paul Watters, the head of European loan ratings at ratings agency Standard & Poor's. "There is definitely a danger of defaults over the next few years, as companies struggle to meet such heavy interest and repayment obligations."

According to Standard & Poor's data unit, LCD, 35 per cent of European buyouts had debt exceeding five times Ebitda (earnings before interest, tax, depreciation and amortisation) last year, compared with just 16 per cent in 2002. Debt levels are even more alarming when capital expenditure is factored into earnings, ballooning to 6.9 times earnings in 2004 - a huge leap from 4.2 times in 2003. "A year ago, five times debt to Ebitda was a high multiple. In the past six months, seven has become the new five," says Mark Vickers, leveraged finance specialist and partner at law firm Ashurst.

Not only are debt levels high, but the proportion of equity in these deals is falling. Usually, buyouts are financed with about 35 per cent equity investment from the private equity firm. The rest of the purchase price is raised in debt. However, equity levels have fallen below 30 per cent for many deals, and some - such as Blackstone's recent buyout of the German packaging firm Gerresheimer Glas - even have less than 25 per cent equity.

Some of the highest debt levels in the past six months include those on the buyouts of the AA, the car breakdown and financial services group, which had a multiple of 6.6 times debt to Ebitda, and of the over-50s holiday and insurance group Saga, at 6.5 times. The electrical equipment supplier Rexel is being bought out with a debt multiple of 6.7 times earnings, while the buyout of the Dutch publisher VNU's telephone directories had a staggering 7.5 times debt multiple. The highest debt levels are appearing on secondary buyouts - where a private equity firm sells to another private equity firm. The Spanish motorway group Itevelesa's secondary buyout has a rumoured nine times debt multiple, while that of French frozen foods firm Picard Surgeles has 7.1 times.

However, it is not these well-known names that experts are most worried about. Even a hefty seven times debt to Ebitda can be supported by companies with stable cashflows, low capital expenditure and swift cash conversion, such as Saga and the AA.

The real problem is that weaker businesses are also being saddled with huge levels of debt now. Cyclical companies in sectors such as retail and chemicals, with high capital expenditure eating into earnings, are frequently getting debt multiples in the high five times earnings range, up from only three to four times a year ago.

"Debt of five times earnings for a cyclical company with high capital expenditure can be worse than seven times earnings for a company with strong and stable free cashflows," says Richard Howell, head of leveraged capital markets at Lehman Brothers.

Having borrowed to the hilt, it would not take much for some firms to come unstuck if interest rates rise or the economic climate deteriorates. "More than a few of the buyouts done in the past six months could default in the next few years," says Jon Moulton, managing partner at private equity house Alchemy Partners. "These over-leveraged companies are walking the plank and it will only take a minor wave for them to fall off and drown."

But why are private equity houses heaping so much debt on these companies?

First, today's low interest rates and the relatively benign economic environment mean that most are still performing well and can afford to take on more debt. In addition, the price of companies is rising, due to fierce competition among private equity firms. These firms have raised huge funds that they need to invest, so rivalry for assets is intense. Also, when looking to sell a subsidiary, instead of approaching one or two potential buyers, as in the past, corporates are holding big auctions. Private equity firms often have to compete against six or more rival bidders, which inevitably pushes up the price. Many companies are now fetching higher prices than they would in the public equity market.

Another reason that private equity houses are gearing up their acquisitions so much is the low growth environment. Private equity firms often look to inject as little equity as possible, in order to achieve the best return on their investment. But today's low growth levels have heightened the need for clever financial engineering.

Although the profits made from buyouts are often claimed to be due to value-added strategies such as cost cutting and restructuring, often a rising market and high leverage do the trick just as well. "The low growth environment means that financial engineering and applying high leverage is often the only way for private equity firms to achieve sufficient return on their equity," says Mr Moulton.

Not all the blame lies with private equity firms, however. Banks and institutional investors, which are willing to lend so much money to them, are also responsible for today's spiralling debt levels. This willingness is partly because default rates are at their lowest levels for years. It is also because, with corporate debt spreads plunging, buyout financing is one of the few areas that still offers lenders attractive yields.

This favourable risk-reward ratio has seen the once-niche market of leveraged finance gain widespread appeal with lenders in the past year. A host of new debt providers, including hedge funds, have swamped the market to lend alongside traditional buyout banks such as Royal Bank of Scotland and Bank of Scotland. In this climate, private equity firms are paying more for their investments while actually stumping up less of their own money.

But will the predicted rash of defaults curb banks' lending habits? The short answer is yes, but not for long. Leveraged finance markets move in a cycle. Debt levels rise and rise until defaults become visible, then banks become cautious about lending again and debt levels plummet. Yet banks have notoriously short memories when high-yielding debt is on offer. As soon as the dust has settled and default rates have tailed off, they will start piling on the leverage once again.

Indeed, for those that have been around for several cycles, the current situation is all too familiar. As Alchemy's Mr Moulton says: "Today's insane debt levels are similar to those in the late 1990s and before that, the late 1980s. After both these periods, the market was hit by a wall of defaults. Yet a few short years later, here we are again."