Soaring leveraged buyout activity fuelled by private equity is creating growing financial dangers to dealmakers, their backers and targeted companies that risks a return to the worst excesses of past merger booms, the International Monetary Fund said yesterday.

In a hard-hitting assessment of the present buyout boom, the IMF sounded a warning that huge investor appetite for backing leveraged private equity takeovers is inflating deal values while leaving acquired companies saddled with increased debt that leaves them financially vulnerable.

The fund also gave warning that big private equity players are increasingly exploiting the strong demand for participation in their deals to extract weaker financing conditions from their backers. At the same time, investors eager to finance leveraged buyouts may also be failing to properly scrutinise these as fully as they should, yesterday’s report found.

“It is likely that some private equity deals will fail to live up to expectations,” the IMF concluded.

The fund’s concern came in its latest twice-yearly Global Financial Stability Review, which highlighted the burgeoning scale of leveraged buyouts amid record global merger activity.

The fund emphasised that the size of leveraged deals is now much larger than in the M&A booms of the Eighties and Nineties. The average size of leveraged buyouts has climbed to $1.3 billion, (£658 million) compared with $400 million in the previous cycle, it said.

While the degree of leverage used in the present round is rising, it remains lower than in the Eighties, the fund reported. However, it found that: “The recent wave of M&A is exhibiting some worrying symptoms of the past and has introduced some new risks.”

Weaker financing conditions were a key anxiety raised in yesterday’s report. It noted that private equity investors were contributing on average only about one third of the price paid for targeted groups, and that this proportion was falling.

In addition, it expressed concern over a “shift in power” from the institutions backing deals to private equity players assembling them, so that borrowers were extracting more aggressively negotiated terms for finance.

“Deal terms have been loosened, as reflected by weaker, fewer, or dropped loan covenants . . . Financing has grown more aggressive,” the fund said.

The appetite of backers to secure a share of leveraged buyout action was so strong that the IMF said that there was concern that some investors were growing reckless over their participation. “Anecdotal evidence suggests that the due diligence performed by investors may be weakening,” it said.

“In the case of deals sponsored by some of the larger and more established private equity funds, investors in leveraged loans may be relying unduly on the due diligence performed by the sponsor and may therefore not perform a full level of due diligence on the firm.”

The fund suggested that the risks of excess in the buyout boom could escalate because of a shortage of appealing targets even as private equity funds continued to rake in additional capital. It said: “It appears likely that in the future more funds will be chasing fewer attractive deals. Already, ratings agencies have warned that the number of viable targets has diminished. The strong demand . . . means that prices are often bid up to levels that represent high values of earnings.”

Acquired companies were also being left in a more vulnerable state by the extra debt piled on to their balance sheets after leveraged buyouts, the fund noted.

“Higher debt levels potentially increase the vulnerability of acquired firms to economic shocks,” its report said.

Yet it suggested that these dangers could be heightened, since private equity groups intent on quickly selling their targets on in so-called “flips” may not have sufficient interest.

“Some market participants argue that the time horizon over which private equity firms are interested in the fate of their investments is much shorter than the maturity of loans used to finance the buyouts,” the report observed.

The IMF concluded that, while the buyout boom was being sustained by benign conditions of low interest rates, high profits and low volatility, any change in these conditions could make these deals “much less attractive”.

It also highlighted the threat that the collapse of a high-profile deal during syndication of loans to back it could have knock-on consequences for financial markets and spark turbulence.

The fund said that regulators should encourage institutions involved in private equity and leveraged buyouts to understand risks and “be prepared for unlikely constellations of risk”. Regulators should also be alert for signs of “weakening of credit discipline and lending standards”.

Behind the buyout boom

— Company balance sheets are strong due to buoyant cash flow and profits, and weak investment

— Private equity groups see some companies as underleveraged and able to carry more debt

— Publicly listed firms that are taken private face fewer regulatory burdens

— Capital is flooding into private equity, with $500 billion (£254 billion) set to be raised this year, up from $430 billion in 2006

— Middle Eastern oil states are pumping petrodollars from soaring crude prices into Western investments

Source: IMF, Global Financial Stability Review

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