Some predicting calm seas, others a tsunami

Depending on who you listen to, there's either doom ahead for private equity returns, or everything's just fine. And that's leaving institutional investors confounded.

One view foresees disaster in 2012, when the estimated $1 trillion in debt from the mass of buyouts in 2005 to 2008 and additional debt that has been extended come due.

Others say private equity fund managers are already handling the problem by refinancing early, issuing bonds with longer maturities and funneling cash into portfolio companies.

“We see the tsunami, but we won't know how bad the impact will be until six months in advance of the maturity dates,” said Ward McNally, managing partner, McNally Capital LLC., a Chicago-based private equity consulting and investment management firm.

Within the next five years, more than $1 trillion of debt is expected to come due, with that sum increasing to $1.4 trillion by 2016, said Michael J. Cerminaro, managing director and co-founder of New York-based Sound Harbor Partners LLC, an advisory firm that provides capital and guidance to private equity firms and their portfolio companies in need of debt refinancing.

“The real crest of the wave is hitting in 2014,” said Mr. Cerminaro, a former BlackRock Inc. managing partner who co-founded Sound Harbor last year with Michael Zupon, former head of Carlyle Group's U.S. leveraged-finance division.

Leverage from buyouts will not be the only wave of debt needing refinancing in 2014, Mr. Cerminaro said. There's a “risk contagion” that will crowd out companies in need of debt. Within the next two to three years, a total of at least $6 trillion in commercial real estate debt, investment grade credit and sovereign debt also will be due for refinancing.

“Where will the risk capital flow to?” Mr. Cerminaro queried.

“It's unknown how the market will continue to persist in the next 24 to 36 months. A lot of (lending) institutions are in rough shape ... It's hard to figure how they will manage their performing loans, let alone troubled loans,” Mr. McNally said.

How much lending banks and other financial institutions would be able to absorb at the beginning of 2014 — the peak in maturity dates from the 2005-2008 private equity heyday — is anyone's guess, he said. The banks' questionable ability to refinance existing loans and make new loans creates additional risk for current funds as well as new ones closed during the next two or three years, Mr. McNally said.

But other industry observers say the brewing storm could blow over.

“They (private equity fund managers) are not waiting until 2014 to refinance it all. They are starting now and will continue,” said Steven N. Kaplan, Neubauer Family Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business. “It depends: If the economy is doing reasonably well, they (the loans) will be refinanced. The private equity firms are aware. If the economy tanks, then there will be problems.”

In addition to refinancing, the best-performing portfolio companies can issue high-yield bonds that have longer maturities to pay down the shorter-term debt, Mr. Kaplan said.

The loans that are being extended are “a mixed bag,” Robert Finkel, managing partner of Chicago-based middle-market private equity firm Prism Capital, noted in an e-mail in response to questions. He estimates that $100 billion of middle-market senior loans are due in 2011 and 2012.

“Some are healthy and just need a little time. Some will need to be restructured. $100 billion of middle market senior loans are due, which is a lot for the system to absorb,” Mr. Finkel wrote. “It will certainly create a lot of opportunities for buyout and mezzanine shops with cash to deploy as they become part of the solution.”

Gary Robertson, senior vice president at investment consultant Callan Associates, San Francisco, has heard both lines of thought.

“A lot of it is that it is a work in progress. It depends how things go from now to then,” Mr. Robertson said. Then he quipped, “In hindsight, it will be perfectly obvious.”

Things will not work out well in every case, Mr. Robertson said. “Selectively, there will be some high-profile problems but not a massive wipeout,” he said. “A few vintage years for those funds raised in late 2006 through early 2008 will look pretty bad, but they will still squeak by.”

“I don't think the economy will grow enough to support the variety of loans,” said Hal Reichwald, partner and co-chair of the banking and financial industry practice of Los Angeles-based law firm Manat, Phelps & Phillips.

While the result won't be disastrous, he added, “I do think it will be rough sledding.“

In the meantime, officials at the Federal Deposit Insurance Corp. are considering new rules that would permit a bank to have loans on its balance sheets that are not carried at market value, while at the same time requiring banks to increase reserves against loans that are on their books.

Starting last year, some big buyout firms were able to extend portfolio company debt by converting it into bonds. While this flurry of activity might be over, there were record high-yield bond issuances, much of it used to refinance bank debt. Still, only the largest 10 to 15 private equity firms are able to access the high-yield markets, Sound Harbor's Mr. Cerminaro said.

“Private equity firms are only now beginning to scratch the surface (of solving debt issues in their portfolios). It is not a solution to the problem of how will they do deals with a looming maturity curve,” Mr. Cerminaro said.

Collateralized loan obligation issuers, typically commercial banks, have been making new loans with capital that comes back from refinancings and mortgage payments. Aggravating the situation is many of these CLOs are expiring and their issuers will no longer be able to recycle the capital into new deals.

“We're in the eye of the storm,” Mr. Cerminaro said. “We're seeing the economy improve a little. We're seeing default rates come down from its peaks. We're seeing banks mend their own balance sheets. But we're at the lowest point in the maturities cliff. In the next two to three years, we'll be in the thick of it.”