Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

Many analysts are skeptical of the growing allure of private equity funds. But not Michael Milken, who helped pioneer the junk-bond market at Drexel Burnham Lambert Inc. 

"This is their golden age," Milken, who pleaded guilty to securities fraud in 1990 and now runs his own research firm and focuses on philanthropy, said in a Bloomberg Television interview on Thursday. 

Private equity firms are collecting huge amounts from yield-hungry investors. This frenzy of cash that's pouring into buyout funds has lasting power, in Milken's view. In large part this is because investors are allowing themselves to be exploited for the gain of private equity owners.

Fund Raising
Private equity funds have had a fabulous time raising money in recent years
Source: Preqin Ltd.

From private equity's standpoint, he said, “You can leverage, you can borrow without covenants, and so for equity holders it affords you very unusual rates of return.”

Milken is right. Junk-bond investors have allowed many protections to be stripped away from securities they buy. 

Debt Deterioration
The quality of investor protections on U.S. high-yield bonds has been deteriorating
Source: Moody's High Yield Covenant Database

This gives corporate borrowers the ability to take on onerous amounts of debt and take more risks that expose them to a greater likelihood of default. On the flip side, creditors stand less of a chance of getting paid back if and when borrowers eventually become insolvent. 

Meanwhile, a greater share of money raised in the leveraged-loan market is going to fund buyouts and acquisitions. And more deals are coming with debt levels exceeding leverage guidelines set by banking regulators, as a Bloomberg News article highlighted on Thursday. The leveraged-loan market has already minted $88.7 billion of debt for buyouts this year, the fastest pace since at least 2011, Bloomberg data show.

It's hard to blame private equity firms for taking advantage of this environment, which they have and, in some cases, pushed as far as they could. “You’re seeing sponsors being very aggressive,” Valerie Potenza, head of high-yield research at Xtract Research LLC, which analyzes debt deals, said in a Bloomberg News article last month. “They are testing the water to see where the line is.”

This is great news for private equity-owned companies, which can borrow loads of money, using some of it to pay nice dividends to their owners. Meanwhile, private equity has had less competition from big banks than in the past. Wall Street firms were subjected to more stringent regulations in the wake of the 2008 crisis, making it less profitable for them to lend.

The problem for private equity firms, however, will come if they push this too far. Right now, benchmark yields are still low and investors are still willing to suspend their skepticism to earn a slightly bigger regular coupon payment. 

Bottom Feeding
Junk-bond yields have fallen to record lows on the heels of monetary stimulus
Source: Bloomberg Barclays index data

 

But if the junk-bond market becomes too fragile because private equity firms have creatively stripped back covenants, it'll be more prone to losses amid a downturn and subsequent investor flight. This will undermine private equity's own companies, which rely on this market for capital.

Also, if they get too big and leverage up too many industries in speculative ways, these firms risk profound and damaging risk to their reputations that could result in more stringent regulation. They are already receiving blame for some of the distress that's taking place in the retail industry.

Milken is right to point out that private equity is getting rich in no small part because of the lax practices of bond investors. But if these buyout firms go too far, they risk jeopardizing their own success.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net