Stand by for new subprime crisis

The strains may not yet be quite as evident but the same toxic mix of ingredients is there - people being offered far too much debt, with the minimum of security and scant regard as to how it might ever be repaid.

Behind this irresponsible lending lay the same assumption on the part of the initial lenders that they would sell the loan on to someone else naive enough to trust them, so that if there was a default it would not be their problem.

As Alchemy's Jon Moulton said at a private-equity conference last week, the debt available for leveraged buyouts grew spectacularly on the back of the structured products boom and the same structures led to the same excesses as in the mortgage debacle.

Bankers competed with each other to see who could drop their standards fastest. And of course they often grossly overpaid for the assets because there was so much easy money around.

The G8 group of finance ministers said a few weeks ago that there is $400 billion of money at risk on subprime mortgages, but given how much privateequity activity we have seen in recent years - think of those multi-billiondollar funds - this figure pales into insignificance compared with the potential exposure to leveraged buyouts. And the big question that no one wants to address, let alone seek to answer, is when all this will start to unravel.

It may not be too long. Many leveraged buyouts are financed for about three years initially. The assumption is not that they will have paid off their debt in that time - indeed they frequently roll up the interest and add it to the sum outstanding - but rather that they will be able to raise new loans to repay the old ones.

This works if the business grows in the meantime under the magic of incentivised management and a benign economic backdrop, and assuming also that the banks still have money to lend.

It becomes more of a challenge if economic conditions deteriorate and the world is in the grip of a credit crunch. So at the very least many of those buyouts from the 2005 and 2006 vintages will be coming up for refinancing this year. So how are they all doing so far? You may wish you hadn't asked. According to credit rating agency Standard & Poor's, roughly half the buyouts done in Europe in the past three years are performing behind budget.

This is not necessarily a disaster, of course, and practitioners at the British Venture Capital Association dinner this week said this was quite common and not really anything necessarily to worry about. They may be right but that is surely not the way to bet in a credit crunch.

Also, most of them work for small to middle-sized houses whereas the excess was largely a mega-fund problem, so it may well be that they are not facing these kinds of issues.

Another way to do a health check is to look at the prices at which some of this leveraged debt trades in the secondary market. Moulton did this for four of the big deals of recent years: Freescale, NXP, Pages Jaunes and ProSeiben. In every case, the senior debt, the most secure, is trading at only 80% of face value.

Given that all these companies are at least four times geared, that means, if the debt is correctly priced, that the equity is worthless. It also suggests that the discounts on the more junior tranches of debt are massive. Refinancing those deals will be challenging.

There are other routes to this similar uncomfortable truth. The average decline in the broadly based indices of the western world's stock markets between June and December last year was 19%. Assume therefore that the value of private-equity financed businesses bought in the immediate runup to last June has also dropped by 19%.

Obviously if these businesses are four times geared, the fall has in effect wiped out all their equity value, and remember how many deals were done at much higher-gearing multiples.

Having equity values at zero does not necessarily mean the businesses are in trouble, of course - I know of quite a few that trade on negative net worth while hoping no one will notice - but neither does it inspire confidence.

It must surely mean that there will be very few recapitalisations, there will be very few secondary buyouts from one fund to another, and there is very little margin for error should trading conditions worsen.

Subprime private equity has the potential to prove just as embarrassing to the world's bankers as subprime mortgages. THEother side of a credit squeeze is, of course, the wonderful opportunities it delivers for those who have cash. Melrose is unusual in that as a listed company it seeks to deploy private-equity techniques and does this rather better than private equity often does. It is now in hot pursuit of FKI, and following an increase in its initial offer FKI has agreed to open its books.

FKI turned down a 130p-a-share offer last year from Blackstone and there is no reason to believe trading is much worse this year. But it is now willing to negotiate around a Melrose offer worth 85p. It has e400 million (£307 million) of debt which has to be repaid at the end of next year and problems in Logistex, a baggage-handling subsidiary that might require significant write-offs. FKI does not have that kind of money whereas Melrose has the balance sheet to take such pinpricks in its stride.

This shows how dangerous it can be to follow financial fashions. Until last summer, the market was in love with heavily indebted companies. Sentiment has turned and that debt becomes a millstone which scares investors rigid, often the samewho urged it to gear up in the first place. FKI is likely to pay for this change of mood with its independence. It is less likely to be the last.