Forgot to hedge interest rates?

LBO fund managers are masters at high-debt management. E.g. in the 2008 crisis we saw some evidence that they refinanced their portfolio companies earlier than others, drew on credit lines more quickly and so, all else equal, went through 2008 quite ok. But here, there seems to have been one basic mistake and, if true (am speculating -- views/insights welcome) would be a big one. Pre 2008, portf. companies had fixed debt repayments (fixed interest rate), banks would normally ask them to hedge the floating part, and junk bonds had fixed coupons. But in the 2010s, tons of debt has been provided by Private Debt (PD) funds, and they all gave floating rates and noone, I believe, bothered to hedge. And in these deals interest coverage ratio was rather tight. Quick Match: you borrow 6x EBITDA at 8% means that half of your EBITDA goes to debt interest repayment alone. Deals were priced to the perfection they said (meaning max debt, max price, growth had to be here for it to fly). Of course no-one can forecast growth, or interest rates, but risk management is about covering yourself against basic things like change in interest rates, and if you are a master of debt, that's basic stuff. So, now interest rates go up and it is not 8% interest payment but 13%, and that is 80% of your EBITDA going to interest payments alone!!! Remember that there are quite a few things that need to come after your EBITDA, like capex!! EBITDA is not here just to pay interest on debt. PD funds are having the party of their life whilst companies are still paying. I would not be surprised if the large amount of dry powder of LBO funds is spent on keeping control of the companies by doing equity injections right now and in the next 12-24 months rather than doing new deals (there will be some but less than usual). There is also an interesting research angle here: companies that had debt provided by PDs face this shock but similar companies who got their debt via other sources won't.

Phafa Le Hardi Written by: