As the credit crunch continues to migrate to new categories of lending, one of the stress points many expect to come to the fore soon is a round of private-equity loans struck in the first half of the decade.
How to handle those loans could be one of the critical questions next year for bankers, as well as for the economy as a whole. Opinion appears divided on how that process is likely to go. The loans may not be the kind of credit bankers would extend today, but some say a round of refinancing is all but inevitable, given the alternative: a major round of commercial bankruptcies.
In a three-year span that started in 2004, when the market was flush with liquidity, private-equity firms used borrowed money to invest in a range of businesses, often targeting out-of-favor ones like department stores and electronics sellers. As with many such investments, these ones were a bet that operations could be improved in relatively short order, with sales of the companies to follow, and that if more time were needed, the loans would be easy to roll over.
Now selling those businesses is hardly an option at all, especially in the hard-hit retailing sector. And refinancing options do not look much better, given the tightness in credit markets.
Edward Kelly 3rd, Citigroup Inc.'s head of alternative investments, put it simply at a conference last week in New York. Many investment vehicles are hurting, he said, but "it's tough in particular for private equity."
Some corporate finance specialists say that in many cases, banks have motivation to work with borrowers — as is happening on the mortgage side of the business — to roll over debt and avoid the ripple effect a rash of insolvent companies would have on the economy and the banks' ability to recoup the money they have lent.
"It's mutually beneficial to everybody involved, whereas bankruptcy could be mutually destructive," Eric Goodison, a partner in the corporate department of Paul, Weiss, Rifkind, Wharton & Garrison LLP in New York, said in an interview last week.
Inevitably, borrowers will face refinancing fees and higher interest rates, but for investors whose equity holdings might be wiped out by a bankruptcy, that may be a price they have to accept. And all involved can postpone the maturity of the debt until what they collectively hope will be better financial times two or three years from now.
"To work these things out, lenders have to step in. There is no functioning credit market right now for leveraged buyers. That will probably be the last market to come back," Mr. Goodison said. "Either the bank provides the refinancing, or it runs the risk of dealing with a bankruptcy that could destroy value and impair recovery of their money."
He represents companies that face maturing debt starting next year, but observers without such connections share his views and see a need to reinvigorate investing in companies.
"If I were a lender right now, my inclination would be to roll unless the borrower is so far gone" that it would do no good, Jeff Davis, a veteran bank analyst and principal at Wolf River Capital LLC, said in an interview last week. "If you have someone you can nurse along, you're better off not putting them in the [nonperforming] bucket yet. It also feeds into the political side, where you can say that you are doing your part to lend and giving someone the benefit of the doubt."
Not surprisingly, private-equity leaders have made no bones about their desire to get some aid from banks to weather a deep downturn — and to invest more freely again in turnaround companies. And they warn of dire times ahead.
Private-equity firms play a big role in making over troubled companies. Last year, at the peak of the latest economic boom, the firms invested about $800 billion in turnaround deals, according to research by Dealogic Inc., a New York technology firm that caters to investment banks.
What's more, in light of Treasury Secretary Henry Paulson's announcement last week that he and Federal Reserve Board officials were exploring ways to use some of the $700 billion financial bailout program to "encourage private investors to come back to this troubled market," bankers who work to modify loans coming due next year stand to bolster their reputations as good corporate citizens helping to ease the country's financial mess.
Still, some fund managers say they have little confidence that companies with lots of debt about to mature will get a helping hand from lenders.
"As companies that can't refinance slam into this wall of illiquidity," it will be "a terrible process for the equity holders, and you want to avoid owning those companies that have upcoming debt maturities," Manny Weintraub, a managing director of money management firm Integre Advisors LLC in New York, wrote in a note last week.
Private-equity firms shopped freely in retail, a sector particularly vulnerable to economic recession. This year several major retailers that have received big investments since 2004 have filed for bankruptcy protection, including Linens 'n Things Inc., Mervyn's LLC, and Circuit City Stores Inc. (which filed this month).
A prime example of the insolvency threat lies within the banking industry itself. When regulators seized Washington Mutual Inc.'s banking assets in September and sold the operation to JPMorgan Chase & Co. for pennies on the dollar, they erased a $1.35 billion investment that TPG Capital LP of Dallas had made just five months earlier.
Observers say bankers have reason to help curb the bankruptcy trend to show that, when it comes to lending, they are still open for business and want to prevent a cascade of business failures that would further stoke economic woes and slow the financial sector's collective return to profitability.
"We obviously have a huge crisis in financial institutions, but the crisis in the economy is just beginning to be felt," David Bonderman, a founder of TPG, said last week at a private-equity conference sponsored by the Asian Venture Capital Journal in Hong Kong, according to Bloomberg News.
Money-center banks with their own private-equity arms also have an interest in supporting a revival of the business. Citi did not provide its expectations for this quarter. But JPMorgan Chase said last week that it expects to lose $500 million this quarter on private-equity investments, a loss that James Dimon, its chief executive, said might stun some customers.
"So when they get — not individuals, but on Dec. 31, when pensions and corporations and people look at their alternative investments and their private-equity investments … I think the people are going to feel more stress," Mr. Dimon said at a New York conference last week. "We are hoping for the best, preparing for bad."