An End to the City's Great Private Equity Boom?
On the 22nd of June, the Office of National Statistics reported that annual inflation had reached 9.1%, the highest rate since 1982. High inflation has been brought on by soaring energy and grocery prices, accelerated by the war in Ukraine, and has forced the Bank of England to increase interest rates to 1.25% (their highest in 13 years). Rate hikes have severely impacted corporate debt markets: by inducing the market price of fixed-interest corporate bonds to fall, they have caused yields to rise.
Bonds are essentially packets of corporate debt issued by borrowers to lenders as securitised assets. They entitle the lender to receive medium-term interest (coupon) payments as well as the principal amount they lent when the bond’s term expires. While a bond’s value can decrease or increase with market conditions, its interest rate remains fixed; the ‘yield’ of the bond represents the return a lender receives from the fixed-term interest payments made by the borrower. Interest rates and the market value of fixed-term bonds are inversely related – this means that an increase in rates, as we are seeing now, causes the face value of bonds to fall. This is an issue for borrowers because the fixed-interest rate they owe on bonds will remain the same despite the overall value of the bond decreasing, meaning the coupon payments they owe to lenders become larger.
Higher interest rates on loans are problematic for private equity funds, as many acquire target companies through leveraged buyouts (LBOs) where the acquisition is primarily financed (up to 90%) through corporate debt. Rising yields are rendering LBOs practically impossible, as private equity funds face paying lenders far higher coupon payments on their borrowed funds. The PE industry is now facing a complete reversal of the market conditions experienced during the pandemic: borrowing is now expensive, demand from investors is low, and the IPO market is in hibernation. Such adverse conditions have seen a dearth in domestic acquisitions from 303 in Q4 2021 to 159 in Q1 2022 (see figure below).
A case in point is the recent collapse of the sale of chemist chain, Boots. Market conditions reportedly factored into the failure of the deal to sell Boots to Wall Street acquisition fund, Apollo, which struggled to arrange the necessary corporate loans to finance the acquisition amid the rise in yield levels. This is merely one in a string of recent collapsed sales – the £1.6Bn sale of Parkdean (the biggest caravan park operator in the UK), for example, was called off due to market conditions.
Market conditions are not set to improve, with inflation likely to rise to 11% by October and one third of the Bank of England’s Monetary Policy Committee already favouring a higher interest rate of 1.5%. This is far from a domestic issue – the US Federal Reserve has already set its key interest rate above the UK’s level, and forecasts a potential increase to 3.4% by the end of 2022. In light of these forecasts, it is foreseeable that the corporate debt market and the private equity industry will be strangled even further as we approach the end of 2022, and continue to suffer before conditions get better.
By Joshua Troup