Hedge funds and Private Equity - PES

Since private equity firms also extract equity from the business they acquire in exchange for credit
in order to satisfy their own investors and fund managers, there is a great risk that they may use
up their equity on the business that they acquire. By the time refinancing has been completed,
private equity companies will frequently have refinanced their equity, i.e. they will have got it back
before reselling.
Furthermore, liquidity and earnings capability are used to service debts; the company is no longer
available to invest in its further development. This risk rises further following reselling of the
company, which is frequently also funded by borrowed capital; in this case, more of the cash
flow is used to service debt.
In addition to the burden caused by servicing borrowed capital, the acquired business frequently
has to mortgage its assets in order to secure loans. Banks providing money for credit-financed
buyouts are increasingly allocating what are known as second-lien loans. These are secondary
loans which, in the event of the business becoming bankrupt, are not repaid until the debts owing
to other creditors have been. However, the creditors are offered higher rates of interest because
of this. This means that the LBO company can achieve greater returns than first-rank creditors 22 .
(%)
70
60
50
40
30
20
10
Evolution of recycled LBO (secondary + recap.)
in total activity of LBO financing in Europe
0
1998 1999 2000 2001 2002 2003 2004 2005
Source : Standard & Poor’s LCD
Private equity assumes unrestricted liability for losses. It is not repaid until the business’s sources
of borrowed capital (creditors) have been satisfied. Given the higher risk involved, private equity
companies demand higher rates of return than creditors.
Capital providers generally have big influence on both strategic and the operational decisions
taken by management. They request wide-ranging rights to inspect internal company data and
to receive ongoing reports. In reality the LBO takes full control of not only the shareholder board
of the company, but also the management of the company. This means in practice making all
relevant decisions including job cuts, investments, dividends to shareholders, financial engineering
etc.
22 Cf. Handelsblatt of 12.5.2005, p. 23.
Part I – Hedge funds and private equity funds – how they work
65