In judging the likelihood of the year ahead it’s always important to see how the last year set it up. And there is no better group of people to follow than private equity firms. I’m not referring to what they have said but rather what they have done.
This year the dividend recap returned in style. Private equity firms borrowed money to pay out dividends to themselves at the highest ever level after the market was essentially shut down in the last two years.
A dividend recap in itself is not inherently bad like debt into itself is not inherently bad. However, what they unmistakably do is reduce the margin of error for the business. It also reveals several nuances about the thought process of private equity firms.
One is that simply debt is free and easy once more. When interest rates are low, investors ‘reach for yield’ and the further away they stray from treasuries, the greater the likelihood of a misjudgment of risk. The second is that IPOs (another way they are able to return cash to their own limited partners) are still essentially a tough proposition. Even if a portfolio was able to IPO then the public still frowns upon the private equity firm taking much cash off the table straight away.
Investors in debt markets remain some of the most puzzling to me: Seemingly they have the most money and the least idea. One is that debt is an inherently safer investment instrument than equity and so you can be dumber because there are less variables and less uncertainty. Default rates are low but precisely because refinancing debt is so easy.
Another looming cloud on the horizon is all of the friendly debt that was used to fuel the large buyout boom in 2007/2008. Friendly terms, like Payment-in-Kind toggles and long dated maturities, meant that it’s simply very hard to actually default on the debt. But that’s only until 2012/2013 when a lot of the excess will run its course.
So in summary, we have the newly issued debt that was used to fund dividends for equity owners in 2010, compounded with the friendly debt that fuelled the buyout boom and that’s all coming soon (companies try to restructure the debt ahead of the logjam). To say that 2011 could be a better year than 2010 in terms of the economy doesn’t seem possible to me.