‘Credit contraction’ is key risk to hedge funds, private equity firms

An avalanche of recent private equity and merger and acquisition deals has helped to generate stellar returns in U.S. equity markets. However, sub-prime mortgage problems have market participants increasingly worried that private equity, hedge fund, and other credit risks are also greater than realized.

U.S. credit markets have witnessed freewheeling growth in recent years, as domestic financial debt jumped from about 83 percent of the gross domestic product in 2000 to 110 percent today. This debt expansion was driven by historically low interest rates during most of the past five to six years, and by a sharp reduction in risk premiums. As global economic growth took off in the 2004-06 period, high corporate profits caused risk premiums to decline. The fact that 2006 was the best year for corporate profits in modern U.S. history had much to do with the fact that the spread between high-yield (“junk”) bonds and AAA-rated securities collapsed to just 230-250 basis points, down from the range of 600-800 basis points during the 2001-02 recession.

The key risk is that a “credit contraction” could further retard an economy already slowing due to a housing market contraction, and raise the risks of a full-scale recession. The dangers that tighter credit conditions hold for the private equity and hedge fund markets are particularly acute.

Private equity concerns

Most private equity deals are heavily dependent upon debt, which is often used to cover 60, 70 or even 80 percent of buyout purchase prices. High buyout prices only make sense if interest rates are low and business conditions remain favorable.
However, if business revenues soften by even a few percentage points, if operating margins slacken or if interest costs creep upward, then these deals could turn sour and borrowers could default on their loans. Many deal-makers now say they are rushing to close their deals before risk premiums rise, as they expect:

• Under-compensated risk. A major investment bank has recently estimated that the current low spreads in high-yield instruments would not have compensated investors for actual defaults experienced for any cohort of five-year corporate bonds since the 1970s.

• BIS warning. The Bank of International Settlements on June 24 warned that it was unclear that “the current level of spreads” was sufficient to compensate for “a return to even modestly higher default rates.”

• Moribund financial-sector stocks. This may also explain why financial-sector firms’ stock prices are languishing in an otherwise buoyant market. While the S&P 500 index is up about 9 percent in the year to date, the sub-index for financial firms is down by approximately 4 percent.

Should the pace of growth slacken or should interest rates rise, many newly privatized firms could be forced to cut costs by firing thousands of workers, contributing to economic weakening.

Vulnerable hedge funds?
Hedge funds and the derivatives markets represent another area of concern. In 2004 the Securities and Exchange Commission passed a rule requiring hedge fund managers to register and submit to oversight, but this rule was struck down by a U.S. Court of Appeals ruling in June 2006:

• Hidden risks? As a result, hedge funds remain mostly unregulated and their risks and true exposures are largely unknown. This is because many hedge funds:

— operate in offshore jurisdictions;

— are very highly leveraged, although the extent of their gearing is unknown; and

— hold securities that are so exotic and idiosyncratic that marking their valuations to market is extremely difficult.

• Major market influence. Hedge funds are now responsible for more than one-third of all U.S. stock trades and control more than $2 trillion of assets. Ownership of hedge funds has moved well beyond the original target clientele of wealthy individuals — those deemed most able to shoulder risk — who now hold only approximately 21 percent of hedge fund assets. Their remaining hedge fund holdings are owned by other funds, endowments and foundations, corporate pension funds, and public pension funds. A few endowments and pension funds now invest 50 percent or more of their assets in hedge funds.

• Financial “shock absorbers”? Many experts, including former Federal Reserve Chairman Alan Greenspan, argue that hedge funds and derivatives act as “shock absorbers” in the financial system and promote risk dispersion. They point to the relatively quiet shutdown this spring of Amaranth Advisers, a hedge fund that suffered $6 billion in losses (due to natural-gas plays), as evidence of the maturity of the sector. In theory, hedge funds rely on many different investment strategies, and should be uncorrelated. However, there was a possible hint to the contrary in May and June:

After risk premiums suddenly jumped by 50 basis points, oil prices dropped from about $70 per barrel to $50, and other commodity prices plunged sharply, and it was reported that approximately 80 percent of all hedge funds lost money.

This suggests that many funds are long on oil and commodities, and might have a hard time if U.S. economic growth should slow further and commodity prices drop.

• Not “stress-tested.” Hedge funds as an asset class still have not been “stress-tested” by a major global economic slowdown or a major economic shock — such as an acceleration of inflation, a trade war, or a full-scale credit-tightening cycle.

Correction ahead?
Prolonged periods of easy credit virtually always lead to “excessive behavior” — namely, overinvestment in what are later seen as undeserving activities. This seems to be a natural feature of modern capitalism. During the past half-century, nearly every episode of credit tightening — as is now occurring in the United States, Europe, China and much of the world — has brought about a sharp collapse of some segment of the financial sector. Examples include:

• the Latin American debt crisis of the late 1970s;

• the U.S. savings and loan meltdown of the late 1980s;

• the Mexican debt crisis of 1994-95; and

• the dot-com implosion of the late 1990s.

Major financial contractions, such as these episodes, have contributed to economic slowdowns and even recessions as evaluations of risk become harsher and as some financial institutions fail or are absorbed by others. In many cases, years of overinvestment simply generate a stock of physical capital — for example, new and unoccupied office towers or houses — that take time to be absorbed by the marketplace, resulting in job losses.
Market implications.
A sharp contraction of the U.S. private equity, hedge fund, or credit markets would have significant market implications:

• Bonds. It would bring about a flight to quality in the debt markets. Government bonds would probably rally, while high-yield bonds would tumble.

• Equities. Less private equity and hedge fund demand for U.S. equities and higher premiums for risky assets would push stock prices lower. This trend would be magnified if the credit contraction had negative confidence effects and discouraged foreign interest in the U.S. markets.

• Dollar. A credit contraction would be negative for the dollar. There would be less foreign demand for U.S. bonds, equities, real estate, and private company shares, translating into less demand for dollars. Slower U.S. growth would also tend to hurt the dollar.

Oxford Analytica is an international consulting firm providing strategic analysis on world events for business and government leaders. See www.oxan.com.