Private Equity Shows Surprising Resilience

The collapse of the EMI buyout was the outcome many had expected for the private-equity industry. Back in 2008, Boston Consulting Group predicted the majority of private-equity-owned companies would default within two to three years.

That now looks unlikely. Most have pulled through, and some evidence suggests financial-sponsor-backed firms performed no worse than publicly listed peers, and in some cases, better.

The financial crisis did take some scalps. Default rates among private-equity-backed firms globally hit 19.4% between January 2008 and September 2009, according to Moody's. But that was in line with 18.6% over the same period for companies with similar credit ratings but without private-equity backing. Size rather than ownership seems to have been the bigger differentiator, with smaller firms finding it harder to survive than larger ones.

Private equity sees boosting firms' operational performance as a core skill. For example, a study from listed U.K. private-equity investment fund SVG Capital showed 2009 earnings before interest, tax, depreciation and amortization fell by an average of 9% across the 50 largest European companies in one of its fund of funds. The equivalent drop for a similar basket of listed European firms was 13%, says UBS.

Private equity argues this shows the validity of its model. For example, the private-equity-owned firms progressively deleveraged, with average net debt to Ebitda levels falling to 4.7 times in 2010 from 6.3 times in 2006, according to the SVG data. Much of the remaining debt has been rolled over until 2014-2016, easing fears of a refinancing crunch.

Sponsors were able to help portfolio companies respond quickly to a deteriorating economic climate. Rather than going through the lengthy and potentially destabilizing process of a rights issue, many owners simply injected fresh capital where necessary.

That suggests private-equity owners may yet exit from some of the companies acquired for huge prices at the height of the boom without losing their shirts, or even turning a profit.

While returns likely won't be those the industry anticipated back in 2008, it is far from the widespread rout many had predicted.

Manulife 4Q Net Soars But Falls Short Of Expectations >MFC

Manulife Financial Corp. (MFC) said Thursday that it's ahead of plan in reducing its earnings sensitivity to equity markets and interest rates, but it was those favorable markets and higher rates that led it to post a record profit in the fourth quarter.

The results, which came after two consecutive quarterly losses, nonetheless fell short of expectations.

Overall, Canada's life insurers were expected to post one of their strongest quarters since the 2008 financial crisis, reflecting rising equities and bond yields. And of the four biggest life insurers, Manulife was expected to benefit the most.

Manulife said net income attributed to shareholders was C$1.794 billion or C$1 a share in the quarter, compared with C$868 million or 51 Canadian cents a year earlier.

The Thomson Reuters mean estimate was for a profit of C$1.09 a share in the latest period.

Toronto-based Manulife had posted hefty losses in the second and third quarters on slumping stock markets and falling rates. The company has more earnings sensitivity to interest-rate and equity-market volatility than its domestic rivals because it has sold more long-term guaranteed product.

In Toronto, Manulife is off 6.4% to C$17.71.

The company also said it's close to achieving its year-end 2012 hedging objectives and believes that its previously stated 2015 net income objective of C$4 billion "continues to be attainable and appropriate."

Rising Rates Should Accelerate Equity, Commodity Price Divergence

China's recent decision to raise the one year Yuan lending rate 25 basis points to 6.06% last night, most likely to fight increases in consumer prices, is an obvious attempt to cool down a rapidly expanding economy. It may also cause the highly correlated commodity and equity markets to de-link from one another, a trend I discussed in February's Searcing for Alpha newsletter. 

Still swooning over the strong earnings recovery in the United States, domestic stocks continue to shrug off bearish news. Commodity investors, however, should eventually realize the importance of the Chinese economy, which according to the International Energy Agency will account for 30% of oil demand growth in 2011 (as well as import a huge amount of other raw materials). It will be interesting to see which asset class folds.

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PSC approves smaller rate increase for National Grid

The average residential National Grid customer won't face a rate increase on their electric delivery bills this year.

A Thursday vote by the New York State Public Service Commission (PSC) also gave the utility permission for an overall rate increase of about $113 million, which is based on allowing the company to earn a 9 percent return on equity.

A typical residential National Grid customer using 500 kilowatts of electricity per month pays about $51 per month for delivery of electric service.

The PSC also anticipates residential delivery rates will remain steady in 2012 and large commercial customers will see a rate reduction next year, PSC Chairman Garry Brown said in a news release.

"Commercial and industrial customers next year could see rate decreases of up to 50 percent," Brown said.

The commission avoided a rate increase in customers' electric-delivery bills this year by preventing National Grid from using rates to recover certain expenses until next year.

Those expenses include post-employment benefits, major storm restoration costs, and site investigation and remediation costs, the PSC said.

At the same time, the PSC allowed the utility to fully recover a charge extended as a part of National Grid's merger with Niagara Mohawk in 2002.

The $113 million increase approved by the PSC is substantially less than the $390 million sought by National Grid when it filed a petition a year ago. The commission determined that $113 million in revenues serves the reasonable needs of the company for this year.

The PSC decided to provide National Grid the chance to earn up to a 9.3 percent return on equity if the company commits to not filing for a general rate increase before Jan. 1, 2012.

If the company does not make that commitment, the return on equity will be set at 9.1 percent.

Default rates slow for European private equity-backed companies

Private equity-backed companies in Europe appear on firmer ground after data from Fitch Ratings showed default rates slowing in 2010 and predicted continued falls in 2011, paving the way for more exits.

According to Fitch, cost-saving measures implemented in 2009 and 2010, combined with economic recovery have bolstered leveraged companies. Defaults by value of debt fell to 5% in the 12 months to September 2010 compared with 5.7% in the first half of the year.

Companies stripping out debt from their capital structures via restructurings and new LBO structures with lower leverage contributed to the improved default rate between March and October 2010, Fitch said.

Corrective measures such as equity injections from stakeholders, cancellation of debt due for repayment as well as improved operating performance and liquidity resulted in upgrades by Fitch of 32% of portfolio companies verging on entering default territory.

Improved risk appetite in the high yield bond and equity markets should ensure further recovery in credit ratings through 2011, the ratings agency said.

Financial sponsors could take advantage of improved market conditions to make exits from investments in resilient sectors with broad geographical reach via strategic sales, public listings and high yield bond refinancings in 2011, according to Fitch.

But the challenge of refinancing a mountain of debt due to mature from 2013 and beyond could present a challenge to European companies, particularly those with weaker credit ratings, according to the agency.

"There are some current circumstances that [leveraged companies] may not be able to rely on in a couple of years," said Edward Eyerman, head of leveraged finance at Fitch Ratings.

"Many leveraged borrowers have stabilised due to cost cuts and low debt service burdens, though they will struggle to restore growth necessary for deleveraging," Eyerman said.

Once this debt matures and requires refinancing, it will become much more costly for companies to service. The average interest on 18 senior leveraged loans rated until September 2010 was Libor+ 475 basis points, compared to just Libor+ 237.5 basis points pre-crisis, according to Fitch data.

Private Equity News reported €32.2bn of buyout debt is due to mature between 2013 and 2016, according to data from Dealogic and Debtwire.

For many leveraged companies, extending the debt maturities in exchange for improved terms could be the best option. "We will continue to see borrowers agree 'amend and extends' with lenders, but the conditions from lenders will be to reprice debt and take out subordinated debt," said Eyerman, citing Gala Coral, European Directories and Alliance Medical as examples of this trend.

Does Rising Rates Really Signal Strong Growth and Rising Equity Prices?

The current fad of those on Wall Street is that rising interest rates are signaling strong economic growth and thus will lead to rising equity prices. Looking at the correlation over the past decade between interest rates and equity prices it would seem that thesis has some merit. However, as the latest monthly commentary from the Contrary Investor points out, the 40 year period from 1960 – 2000 tells a very different story.

Where a correlation exists between equity prices and interest rates (indicated by the 10 year treasury) during that period, it has overwhelmingly been a negative one. For example during the 1980′s the only time equity prices and interest rates moved in a positively correlated fashion, ie they both went up together, was in 1987 and we know how that worked out. Similarly the only time in the 1990′s that interest rates and equities went up together was 1999.

Thus the latest Wall Street fad is predicated on the back of the previous decade that saw equities cut in half twice and a generational plunge in home prices. Is it a coincidence that the entire period of the last decade where a positive correlation between equity prices and interest rates existed was one in which the Fed was overly accommodative? Or less politely put, blowing bubbles? Is that not what we have now, as the Greenspan put has seamlessly transitioned into the Bernanke put?

Another important point from the contrary investor worth considering before buying into the 'rising rates equals strong economic recovery' story:

If you bring the TIPS yields into the analysis and look at the trajectory of inflation breakeven rates, it is absolutely clear investors are pricing in higher inflation with the higher interest rates we have seen as of late as opposed to supposedly pricing in a big improvement in the domestic economy. The Street seers don't seem to bring this into the analysis at all when pointing to how bullish a sign higher interest rates supposedly are for equities.

So sure, with Fed policy now officially aimed at raising equity prices, we can envisage a period of time when interest rates and stocks can rise in tandem. However we've seen this movie enough times before to know that it never ends well.