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Spectre at the feast

Gloomy prophecies of a credit crunch haunt the private equity sector

Is the Bank of England becoming an economic Cassandra? In its recently published annual review of financial stability, it identified a credit crunch followed by a crash in asset prices as one of the key risks to the stability of the financial system.

It has warned before about the risk of a fall in one area of asset prices – the housing market. The argument that homeowners may have borrowed too much to finance purchases of over-inflated homes is by now familiar. For those who have borrowed too much, a fall in house prices could be devastating. It has not happened yet, prompting some to accuse the Bank of England of behaving like a doom-laden medieval soothsayer.

But the spectre of a credit crunch and falling asset prices could be haunting more than just the housing market. The economic principle behind it is that credit has been relatively cheap for a relatively long time. Low interest rates mean cheap money and that encourages people to borrow to buy assets like companies, shares or property, pumping up prices to artificial, unsustainable levels.

One phenomenon driven by the cheapness of credit is the relentless rise of the private equity sector. Groups like Permira or Apax have been popping up in takeover situations in almost every sector of industry from financial services to seaports to retailers. They can borrow so cheaply on the money markets that all they need for a takeover target is not a company with great growth or recovery prospects but simply one with a decent, predictable flow of cash to allow them to repay the low rates of interest.

If property continues to rise, they can expect to repay much of what they have borrowed by, for example, selling a few assets once they have won control. These sort of leveraged buyouts are so lucrative that merchant banks like Goldman Sachs do not want to miss out on the action. They are heading consortia all over the globe looking to take over businesses, not so much because they think they can make more money by managing them better but because, by being geared, they can make a faster buck than the companies themselves.

The Bank of England fears that this may encourage companies to go on the defensive by gearing up themselves and taking on more debt. A retailer can boost its profits and defend itself against takeover by borrowing money to open more shops but it may not be a sensible strategy.

The Bank of England is not alone in its gloomy prophecies. The private equity industry itself agrees. Sir Ron Cohen, the head of Apax, and Jon Moulton, from private equity group Alchemy, have both made similar noises. Cheap money is encouraging companies to borrow more, gear up and take leveraged bets on investments. Moulton warns that there could be “a big mess” if credit becomes more expensive. Just as with the housing market, the motor for higher asset prices – the availability of cheap credit – could suddenly start sputtering. Gears can go into reverse and levers swing in both directions.

Why should IFAs care? Because this is where their clients’ money is going. If the Cassandras are right, there is a strong possibility that money may be buying shares too expensively because the prices have been pumped up by all that takeover activity, prompted by all that cheap credit. If it is a bubble and it goes pop, so may the client’s investments.

Identifying a risk is not the same as saying it is going to happen. The Bank of England is at pains to point out that it does not regard the nightmare scenario of a credit crunch followed by a fall in asset prices as the most likely one. It may not even be a serious threat but, by identifying it, it is at least saying that it is a risk.

It may be that the Bank of England and the private equity groups are wrong to make such portentous noises or it may be that they are right – but not yet.

Andrew Verity is a financial presenter on Five Live


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