Financial markets have been in turmoil over the past seven weeks, triggered by the US sub-prime mortgage crisis. Thousands of column inches have been devoted to analysing the root causes of the turbulence and the potential effect over both the short and mid-term.
The one common theme to emerge is that nobody quite feels yet, with any certainty, that they know how things will shake out.
The slicing, dicing and repackaging of debt in increasingly complex and opaque ways will make it almost impossible to identify who holds the ‘toxic waste’ behind the current lack of market confidence, until the holders admit to it themselves. This lack of clarity has left the markets in limbo, with billions of dollars of suspended deals still out there.
A more cautious approach will permeate the markets, at least for the mid-term, with a return to tighter risk management. The days of covenant-lite and bank-style equity bridges are long gone in the private equity world. There is likely to be a further delay in new leveraged deals coming to market, while major banks that were left holding as much as $360bn (£178.67bn) of underwritten, but as yet unsyndicated, debt over the summer seek to clear their balance sheets.
However, private equity firms are awash with cash to invest, so it is likely this market will bounce back, albeit on more traditional credit, leverage, covenant and pricing terms, which some would argue is a positive market adjustment in any event.
The pace of the recovery will depend to some degree on how quickly the banks can push the backlog of loans into the market and at what price. In the meantime, cash-rich corporates, previously squeezed out of the market by the private equity surge, will seek to take advantage of the current conditions, so good M&A lawyers are likely to stay busy.
The spread of the sub-prime contagion to hedge funds, as well as to the collateralised debt obligations (CDO) market and structured investment vehicles (SIVs), is likely to raise the temperature for contentious claims.
More positively, there are likely to be calls to restructure the complex make-up of these vehicles in order to weather the storm rather than see a disorderly sale under rules not suited to the current irrational sentiment. Insolvency firms are likely to be busy dismantling failed investment vehicles, with the most likely suspects being the quantitative hedge funds and funds focused on CDOs that have fallen foul of market conditions.
Although the current credit market correction has impacted all asset classes in some way, there are as yet no signs of the brakes being applied to global economic growth. The global outlook remains broadly positive, with new drivers of the world economy, such as China and India, still going strong and corporate balance sheets looking in good shape.
It is unlikely we will see leveraged defaults and restructurings in the short term, particularly in light of fewer amortising pieces of debt in current structures and seemingly a freeze on the upward trend in interest rates. However, if conditions do take a turn for the worse, firms with insolvency and financial restructuring expertise will be more resilient.
The ability to adapt rapidly will be key. Quality law firms with breadth and depth of global reach, coupled with diversified strong product mixes, will be best equipped to succeed in these uncertain times. The legal industry is generally better prepared than ever to deal with uncertain markets, having learnt some important lessons from the past.
Hopefully the markets will stabilise and the investor confidence and liquidity, albeit in a more rigorous and risk-conscious environment, will return.