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part 1 of The Times credit crunch series
What a difference a year makes. Last Christmas, bankers were giddy with M&A
fever. Mountains of cheap debt had fuelled a private equity merger boom that
kept investment banking profits sky-high and the pipeline of deals for 2007
was stuffed to the brim.
But there is scant Christmas cheer in the City this festive season.
Multi-billion-dollar bank writedowns and thousands of job cuts have put a
dampener on celebrations, while the prospect of a recession is casting a
pall over the new year.
Vic Daniels, the founder of thisisthecity.com,
a handy gauge of sentiment in the Square Mile and Canary Wharf, said that
2007 was ending with a “bump rather than a bang”.
“A lot of staff are happy to be keeping their jobs, rather than worrying about
the size of their bonuses,” Mr Daniels says. “People aren’t suicidal but
they are worried about 2008.”
The pain in London was triggered by the injudicious sale of mortgages to poor
Americans. US banks had packaged up millions of these mortgages and sold the
resulting collateralised debt obligations (CDOs) and collateralised loan
obligations (CLOs) to investors around the world. When homeowners defaulted
in droves, investors such as banks, hedge funds and structured investment
vehicles (SIVs) suffered huge losses.
The same banks and CLO funds had been funding the private equity boom with
highly leveraged loans on favour-able terms. After sustaining big sub-prime
losses, they shied away from high-risk investments and refused to buy the
syndicated leveraged finance.
As a result, the underwriting banks got stuck with billions of dollars worth
of unsyndicated loans and have been forced to stop lending, stalling several
takeover deals.
As the economic outlook continues to worsen and fears over a recession in the
US or the UK, or both, grows, experts say that there is little hope of a
full recovery for the financial sector in 2008.
Adrian Beecroft, chief investment officer at Apax Partners, the UK private
equity firm, predicts that the slow-down in private equity deals will
continue in the first half of this year. “I think that the first six months
will be very quiet,” he said. “It certainly looks like there’s going to be a
recession of some sorts that will make things more difficult for portfolio
companies [companies owned by private equity firms] and it will also hit the
number of transactions that can be done as buyers will wait to buy, thinking
that the value of the business will fall, and sellers will wait to sell,
thinking that they might get a better price. In the interim, while there’s
uncertainty, nothing will get done.”
Bankers working in leveraged finance say that the syndication market failed to
recover in the second half of 2007 and remains “constipated”, with an
estimated €100 billion (£74 billion) worth of finance still to be
syndicated. One described the loans to Kohlberg Kravis Roberts and Stefano
Pessina to fund their £11.1 billion Alliance Boots acquisition as the “900
pound gorilla that's clogging up the market”.
The majority of the debt is yet to be sold. “Until more of that gets away, the
market for fresh primary offers is totally shut down and will remain that
way well into the new year,” the banker said.
The outlook for corporate mergers and acquisitions is more positive, although
the same worries about a downturn in the economy linger. Gavin MacDonald,
global head of M&A at Morgan Stanley, said that the deal pipeline for
2008 looked good.
“A lot of the corporates are in good shape, although it’s sector specific and
there are several consumer-facing businesses that are showing weakness,” he
said. “That said, corporate activity is tied to economic growth so if we go
into a recession, that may slow things down considerably.”
Tom King, the head of Investment Banking at Citigroup for Europe, the Middle
East & Africa, said that last year’s momentum had been replaced by “an
incredible amount of uncertainty” going into 2008.
He said that the worst-case scenario was a complete meltdown, similar to the
last technology-related boom in 2000-2001, where overnight all M&A and
market activity, “just completely fell off a cliff”.
But there are a number of key differences this time round, he said. In the
last boom, companies were hugely overlevered and their balance sheets
collapsed as the economy weakened.
But this time around, corporate balance sheets are still strong and the desire
to do deals – to fuel expansion and target emerging markets – is still
compelling.
He pointed to BHP’s £62 billion bid for rival Rio Tinto – the biggest deal of
the year if completed – as an example of corporate M&A continuing
regardless of the mounting credit crisis. “So whatever the year ends up
looking like is going to be a function of how some of these uncertainties
play out,” he said.
“M&A is fuelled by confidence, strong markets and liquidity so as
you start chipping away at each of those then the pace will slow.” Mr King
said that along with other banks Citigroup, whose chief executive Charles
Prince was ousted in the wake of the credit crunch, had to work out two
scenarios for 2008: a cautious scenario and a disaster scenario.
“You like to be optimistic but you like to plan for all scenarios which is
what we’re doing,” he said.
David Bernard, the vice-president of investment banking and private equity at
Thomson Financial, believes that medium-sized companies will escape many of
the financing problems that have hit the giant deals. “We’ve seen M&A
volumes in the second half of the year affected by the credit crunch,
particularly mega-buyout deals, which have dropped off sharply,” he said.
“But the mid-market has remained buoyant and we continue to see deals
getting done.”
Deals involving small companies will also be resilient next year, although
they also will face tighter credit conditions at the banks, according to
Nick Soper, head of debt advisory at Investec.
He said: “For smaller mid-market UK corporates, say those looking for debt
financing of up to £100 million, the market is still open but the banks are
now being selective on which transactions to support”.
At a Treasury Select Committee meeting this month, Jerry Corrigan, a managing
director at Goldman Sachs and co-chairman of the bank’s global risk
management committee, told MPs that many of the highly complex structured
credit products would die out in 2008.
Many companies that lost money in the credit crisis did so through their
purchases of asset and mortgage-backed securities that were backed by risky
US home loans.
He predicts a return to more easily understood investments. “There will be a
whole class of structured credit products that go the way of the dinosaurs.
There will be a permanent retrenchment from these kinds of products, base on
the experience of the last couple of months.”
Mr Bernard said that there was a possibility of recovery for structured credit
products, but only those backed by select assets. “I expect the primary
market to remain largely closed for those instruments in the first half but
reopening later in the year, except for those securities backed by US or UK
mortgages.”
Figures from Ernst & Young show that London initial public offerings fell
75 per cent in the third quarter, mainly because of uncertainty in the
capital markets following the credit crunch. Brokers do not expect a great
improvement in the first half of 2008.
Luke Ahern, from institutional sales at BlueOar Securities, said that investors
were interested in small caps that had strong growth potential.
“In the large caps, people look at companies very selectively. The door isn’t
closed but it’s not far off. I don’t expect it to be busy until after June
[because] there’s a lot of macro-economic issues that need to be resolved,”
he said. “If anyone expects 2008 to get off to a roaring start, they’re on a
different planet to me.”
In fixed income, where many of the sub-prime losses have been sustained, the
flight to quality will continue, with high-quality corporate bonds winning
the favour of investors.
Toby Nangle, a fixed-income fund manager at Baring Asset Management, said that
he expected corporate bankruptcies to rise as capital remained scarce,
giving investors even greater reason to stick to blue-chip bonds.
“Lower-quality corporate bonds will likely have another poor year in 2008 as
risk premiums rise to reflect the worsening economic environment in the US
and Europe,” he said. “Investors will be likely to shift out of weaker and
into the bonds of stronger companies.”
Looking down the deal pipeline
Deals pending
— In November, BHP Billiton announces £76 billion offer for Rio Tinto to
create world’s largest mining group
— In March, Imperial Tobacco Group announces £10 billion offer for Altadis of
Spain
— In October, the Continental brewers Carlsberg and Heineken announce £9.2
billion offer for Scottish & Newcastle
— In May, Thomson Corporation of Canada announces £9.2 billion offer for
Reuters
Deals completed
— In October, Royal Bank of Scotland, Fortis and Banco Santander paid £48
billion for ABN Amro
— In October, Rio Tinto paid £21.5 billion for the Canadian group Alcan
— In June, the US private equity giant KKR paid £11.1 billion for Alliance
Boots
— In August, Heidelberg Cement of Germany paid £9.3 billion for the UK
industrial group Hanson
Deals abandoned
— In April, the private equity group CVC Capital Partners drops £11.6 billion
offer for J Sainsbury
— In November, the Qatari-backed Three Delta drops £10.6 billion bid for J
Sainsbury
— In March, Vodafone drops £2.8 billion offer for 33 per cent stake in India’s
Hutchison Essar
— In November, the Italian utility ENI drops £1.5 billion bid for Burren
Energy of the UK
So there is some good news then..
DickW, Aberdeen, Scotland