S&P sounds private equity alarm

The quality of debt backing private-equity deals has fallen dramatically, Standard & Poor's has warned.

The ratings agency's research shows that at the end of August the loans backing three-quarters of European private-equity deals were rated in the single "B" range of junk debt.

This means there is a one in five chance of the companies taken private using the loans as finance falling into default.

That is a sharp decline compared with the situation at the end of 2002, when the agency started compiling figures: less than one-third of debt was rated in the B range, while 57 per cent was rated in the BB range - just below investment grade. At that level, the risk of default is just one in 20. Currently only one in 10 deals has this rating.

The S&P figures back up the City watchdog's fear that the failure of a major private-equity deal is "inevitable".

On Monday, the Financial Services Authority sounded alarm at what it called "excessive levels of debt" being used by private-equity firms to buy companies.

Paul Watters, the head of loan and recovery and ratings at S&P, said the reason for the sharp decline in credit quality is that new deals are being financed in an increasingly aggressive manner.

He warned that companies taken private are having to clear ever-higher hurdles to meet the interest charges on the debt used by their private-equity owners to finance their acquisition.

Several private-equity firms have also been loading ever-more debt on to businesses they already own to enable them to take substantial dividends out.

While Mr Watters said there had been relatively few failures since S&P started collating the figures, due to "an exceptionally benign environment" he warned this was likely to change radically.

"Critics might say we are being overly conservative in the way we look at this debt. Default rates are currently at historic lows. There is quite naturally a question as to whether we are being too conservative.

"But we are just highlighting trends as we see them and we could easily be moving into a period where defaults become much more common," he said.

"Our message is that as credit quality declines, the important thing for lenders is to look at the potential downside. They should also be looking carefully at what they think the recovery may be at the end of a restructuring."

The FSA would not comment on the S&P figures yesterday, but its lengthy report into the sector raised concerns about "significant and rapid downgrades" in the sector.

It also voiced fears about the increasing complexity of the financing arrangements used to back private equity deals, warning that this could prevent successful rescues of stricken companies.

Private-equity deals are booming, and the number of companies being taken private outstrips the number of new companies being brought to the London Stock Exchange.

Many banks which lend to private-equity firms typically seek to lay off some of their risk by means of complex financial instruments, such as credit derivatives.

This concerns regulators because it makes it difficult to work out who holds how much debt when a company finds itself in difficulties.

However, the private-equity industry has warned that increased regulation could threaten the success of the industry, which employs hundreds of thousands of people across Britain.