Private Equity's New Clothes

In the Hans Christian Andersen fairy tale, "The Emperor's New Clothes," there is a pivotal scene near the end of the story where a small child shouts above the din of a delusionary crowd that the supposedly bedecked ruler has no clothes on. I doubt it, but maybe the warnings from accounting firm Ernst & Young in "Private Equity Predicted to Spark Company Collapses" will engender a similar turnabout in sentiment among the cheering mob of private equity enthusiasts.

A string of corporate collapses is likely next year as debt-laden private equity deals begin to unravel, a leading firm of accountants said yesterday.
The complexity of the deals and the timing of debt repayments will undermine companies that under previous ownership structures might have survived, said insolvency experts from Ernst & Young.

The firm's analysis of corporate buyouts and potential losses for investors is likely to increase pressure on private equity firms under fire from unions over job cuts....

Keith McGregor, an insolvency partner at Ernst & Young, said the complex nature of many private equity deals was likely to make them more prone to collapse if they suffered a downturn in sales or increase in costs.

"The quality of the debt has dropped off in the last few years. Debt with a CCC rating has a one in three chance of going bust within two years. But it is the fastest growing element of debt in private equity structures," he said.

He said the situation would worsen next year when a significant increase in costs would begin to hurt companies when they needed to fund the second tranche of their debt repayments. The first level of debt, known as senior debt, is paid back in instalments and lenders have the first call on the company's assets if it should go bust. The second and third tier of debt is typically paid back after four and six years respectively.

Then again, maybe not.