By Amy Or
NEW YORK--Private equity firms are gearing up for a possible
deterioration of the sovereign debt crisis in Europe and an
extended period of low economic growth, through a mixture of
refinancing and hedges.
Making sure European investments stay in business while not
jeopardizing returns by European nations' onerous debt and
austerity measures, along with slowing economic growth, has been in
sharp focus of late for investment managers and their clients.
"Everyday is a brand new soap opera [in Europe]," said Carlyle
Group LP (CG) Chief Operating Officer Glenn Youngkin at a Morgan
Stanley (MS) investment conference earlier this month. "What we
need to do is to protect our 33 portfolio companies in Europe by
shoring up their capital structure."
Carlyle, managing $159 billion assets worldwide, has refinanced
its portfolio companies' debt over the past six to eight months
including some deals which Youngkin described as "Herculean" on the
rising cost of refinancing there, to make sure they will withstand
an extended downturn.
The European debt crisis has brought an increase in corporate
bankruptcies, but the rise wasn't as severe as expected given the
magnitude of shock to the financial system. Rating agency Standard
& Poor's said Europe accounted for only four, or 7.5%, of the
53 global corporate defaults last year, the U.S. and associated tax
havens like Bermuda and the Cayman Islands, meanwhile, accounted
for nearly three-quarters of bankruptcies that year.
Abundant bank financing and liquidity from central banks played
an important role in allowing businesses to continue operating over
the past few years. But as European banks face regulatory
constraints on capital and they still hold a substantial amount of
European sovereign debt, concerns have resurfaced over their
ability to provide market liquidity to limit the damage of future
crises.
The amount of private equity investments in Europe is
significant. Since 2009, about $220 billion has been put to work in
deals there, according to data provider Preqin. With the European
influx, many investors, including those in the United States, are
exposed to political, economic and currency risks on the
continent.
For example, KKR & Co. (KKR) suffered discounted return from
its partial divestment in Alliance Boots earlier this month due to
a sharp decline in the pound against the U.S. dollar. KKR's GBP1.2
billion investment in 2007 cost $2.45 billion in U.S. dollars, but
the same amount is now worth only $1.8 billion. The over 25% loss
in the sterling alone slashed the buyout giant's return on capital
by 18%.
While forward contracts and other investment instruments can
hedge against currency fluctuations, some private equity
managers--particularly those with long-term investment
horizons--are hesitant to place directional, foreign-exchange
wagers.
"We don't take directional macro positions. If Germany leaves
the euro zone, the euro may collapse, if it's Greece, the euro may
rise," said New York Life Capital Partners' Managing Principal
Quint Barker. "Our expectations are that over the life of a steady
program, the benefits and losses from currency will balance
out."
New York Life Capital Partners, which managed about $8.8 billion
in alternative assets as of March 31, for institutional and high
net worth investors, including parent company New York Life
Insurance Co., only puts on short-term currency hedges when it
expects a specific profit distribution and has related concerns
about currency movement.
But often, Mr. Barker said his firm deems realization of
investment gains "too far out to have a hedge put on it" with
little clarity on their size and timeframe.
AXA Private Equity, a unit of French insurer AXA SA (AXAHY,
CS.FR) with $28 billion assets under management, takes a similar
position.
Dominique Gaillard, AXA Private Equity's managing director of
direct funds, said instead of trying to hedge the unknown, his firm
focuses on investing in three core European countries: France,
Germany, and Italy.
He said even in Italy, where the environment appears shaky at
the moment, the firm can still find companies that are less
dependent on the state of the nation's finances.
"If the euro depreciates, it would be beneficial to the
country's exports as sales will go up," he said.
AXA Private Equity also finds refuge in non-cyclical market
leaders. Gaillard said one example is its EUR150 million investment
in a Milan-based provider of care homes for senior citizens,
rehabilitation services, healthcare centers and hospital services,
where there's growing demand.
Earlier this week, AXA Private Equity bought an 82.4% stake in
Italian rubber component manufacturer Novotema Group. While based
northeast of Milan, Novotema generated only a third of its revenue
from Italy. Over half of its income comes from Germany, AXA Private
Equity said.
Write to Amy Or at amy.or@dowjones.com