Stalled private equity market makes way for corporates

So, August is over and the frenzied credit crunch obsession, which has kept the non-holidayers among us amused over the summer, continues apace. Now that all but the truly hedonistic are back at their desks, the job of quantifying the impact of the squeeze can begin in earnest.

Private equity has been the story of the City so far this year, with mega-deal after mega-deal hitting the headlines in the first half of 2007. Given the highly leveraged nature of the bulk of the industry's transactions, the fallout from the sub-prime market's collapse has undoubtedly made itself felt in the private equity world.

But is this just a blip in an otherwise rampant market? Or have the brakes well and truly been slammed on? More importantly, given the high number of transactional lawyers peppered across the City, is the private equity deal flow destined to dry up?Lovells private equity partner Tom Whelan feels that the squeeze on credit has had a huge impact on deals so far, particularly those at the top end of the market. Those with more of a mid-market focus, typically around £150m or less, should be fine, he says, although there could still be some jitters on the horizon.

"There's something like e80bn [£54.65bn] worth of undigested debt that hasn't been syndicated - that's about six months of historic debt that hasn't been digested," says Whelan. "There's nothing moving that on because there's no liquidity and banks can't lend further if they can't get rid of it. Things are drying up in terms of funding other deals. On larger deals, because there is so much more debt to digest, it's harder to find the appetite to do it."

The implication is obvious: if banks are going to be left with £2bn worth of debt that they cannot syndicate, their enthusiasm for a deal will evaporate quickly . Of course, at the moment nobody is certain how the markets will move in the coming months, so pulling out of deals is not a route many would want to take. Instead, banks are seeking to renegotiate terms with private equity houses to get better pricing. This is good news for corporate lawyers, as it means they can still get their deals away, while their counterparts in finance can expect some additional work to come their way.

"Generally banks are funding these deals in the knowledge that they will lose the syndication because there's no appetite for debt," says Whelan. "They're realising that they need better terms if they're to keep the debt, given that they'll have it on their own balance sheets for a while. So deals will still proceed, but they will be less attractive for private equity houses."

O'Melveny & Myers corporate finance partner Stuart Hills agrees that renegotiation is having to take place, although he points out that the uncertainty caused by the sub-prime situation is making the prospect of fresh deals less and less likely.

"If people are worried about deals they can normally structure around the worries, but if they're uncertain about what's really going on and question whether they've priced deals right, there's nothing they can do but pull the shutters down," he says. "Covenant-lite deals have made the banks very nervous and that's had an impact on them trying to syndicate the deals they've committed to. When that happens you end up in a position where you have to stop, work out what's going on and work out what liquidity's going to be like in future before you can carry on."

In general, banks are starting to exercise their right to use the market flex clause on existing deals, a move that is unattractive to private equity clients.

"Where existing commitments have been given by banks the deals are still going ahead, but the banks are having to do them with the risk that they won't be able to syndicate them," says Hills. "The problem with that is that in the standard documentation for these deals there are various provisions that allow banks to change the deal to make it syndicatable. A number of deals, such as the Alliance Boots one, have been subject to that. The effect on private equity in general is that terms are changing by the use of market flex and new deals are proving very difficult.

"Until the banks know where they're at and have a view on market liquidity they will not write new commitments."

But it is not all doom and gloom for transactional lawyers. As Herbert Smith corporate partner Gavin Davies points out, if debt issues are going to keep private equity away from the deals table, corporates with strong balance sheets will be able to find their way back in.

Whelan adds that corporates will find it much easier to do deals in the current credit climate because they are far less leveraged than private equity when it comes to bids. "Because they have less leverage they can borrow more and have more assets for their borrowings to be secured against," he says.

SJ Berwin corporate finance partner Tim Wright agrees. "This is a good opportunity for corporates to come back into the market and pick up some of the deals they couldn't get onto because private equity was there," he says. "It will bounce back though, as private equity has lots of money that needs to be spent."

And, as Hills points out, market corrections always create opportunities as well as issues. "For private equity houses, should they move into distressed debt, there are clearly some deals to be done there," he says.

The summer's jittery markets have definitely stalled the juggernaut that was the private equity market. Whether it can regain its position at the head of the M&A market remains to be seen. Certainly, fundraising continues unabated and there is plenty of cash waiting to be invested, although, without the associated debt that has become the mark of private equity acquisitions, exactly where and when it will be invested is uncertain.

But this is not necessarily a bad thing. As Whelan says: "I think it's a good time to draw breath. We were getting to the stage before the credit crunch where there was a lot of antipathy towards private equity because it was seen as taking a pop at lots of household names.

"It's almost as though this has brought a reality check to the market. It gives private equity a chance to get its own house in order, but also shows that the debt markets will stop them doing bigger deals."