Ben Chu: The day of reckoning for the private equity barons is still to come

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The Independent Online

Outlook Remember the buyout barons? Before the 2008 financial crisis there seemed to be three ways in which financiers could become insanely rich, obscenely quickly.

They could work for megabanks, collecting multibillion-pound bonuses every year. They could run hedge funds, charging disgustingly large fees to naïve punters. Or they could buy and sell companies, using cheap loans from banks, earning the kind of paydays in the process that would make a Roman emperor blush.

The high water mark for the private equity boom was the £11.1bn acquisition of Alliance Boots in 2007. One in three companies sold in the UK in those balmy days was acquired by private equity. Outside the public sector, a fifth of workers were employed by companies in private equity ownership.

No target was too big. Even Sainsbury's was being stalked at one point by the big money buyout boys. People such as Damon Buffini of the European private equity giant Permira were catapulted into the public eye as symbols of our era of quick-buck capitalism.

Dragons' Den-style private equity for start-up firms is a wonderful and unquestionably socially useful thing. But the kind of mega-deals done in the boom, though presented by the industry as a brilliant new way to make established businesses more efficient, were always spivvy and reckless. Public companies would be bought out, loaded up with dangerous levels of debt, before being flipped for a sizeable profit into a rising stock market. There was no real added value, merely financial engineering. And the risks –all that debt – were disguised.

The public have generally acquired the number of the too-big-to-fail bankers since the bubble burst. The reputation of the hedge fund honchos has been shattered by the catastrophic losses suffered by this supposedly "absolute return" industry in 2008. But what about the third leg of this get-rich-quick financial tripod? What about leveraged private equity?

We have heard surprisingly little from the industry in the five years since Lehman Brothers sank. There were predictions in 2008 and 2009 that all those deals done at the top of the market, fuelled by cheap money from the banks, would inevitably unravel. The companies taken over by the buyout boys would be unable to refinance their excessive debts. The cashflows from the acquired companies would struggle to cover the interest payments.

In fact, not much has happened. True, there's been the collapse of the purchase of EMI by Guy Hands' Terra Firma, a deal which has lost investors millions. Yet the great cascade of insolvencies and crippling private equity writedowns never happened. So were the prophecies of doom misguided? Was this, all along, a responsible industry run by shrewd and temperate men?

Not so fast, says the Bank of England. In an article in the Bank's latest Quarterly Bulletin, David Gregory argues that the sector has been propped up by low interest rates and forbearance by the banks. He points out that a third of the major UK banks' leveraged loan exposures to European companies are benefiting from forbearance. And this debt is trading in the market at levels which imply high expectations of default.

Mr Gregory also notes that the real test of those top-of-the-market, debt-saturated deals is yet to come, since positions aren't generally exited by private equity firms for a decade. When it comes to those perilous leveraged deals signed at the height of the bubble in 2006, we won't know until 2016 how they have performed. And before then there's a refinancing hump in 2014 for many of the boom-era leveraged buyouts. This isn't over. The day of reckoning for the buyout barons is still to come.