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Private equity debt bubble

Kevin Landry was searching for someone with a particular background to speak at the annual meeting of sophisticated investors in the private equity funds managed by TA Associates. He wanted someone who made a living in the world's debt markets.

"They can't understand our business unless they understand what's going on there," says Landry, chief executive of the Boston private equity firm.

Private equity firms are raising gigantic new funds, which in turn are buying companies on an unprecedented scale. The targets are bigger than ever, and the deals are gushing at fire-hose volume. But that isn't just a function of all the billions raised from limited partner investors. Borrowed money is the real fuel driving an overheated market.

"I think of this as a debt bubble, not a private equity bubble," Landry says. "That's the horse, and we're the cart."

Debt markets that finance private equity transactions have changed in three important ways. They are charging lower interest rates, reducing the premium normally charged for greater risk. They are lending more money for the purchase of an operating company, exceeding normal caps based on the cash generated by the acquired business. Finally, debt markets are reducing or virtually eliminating covenants and other rules that now make it almost impossible for private equity investors to default on loans used to buy companies.

Got that? Low rates, more leverage, practically no conditions. How do you think that story is going to end?

"The reality is the markets are willing to provide extraordinary amounts of debt, almost indiscriminately," says Scott Sperling , copresident of Thomas H. Lee Partners, the big Boston private equity firm. "It's hard to put these companies into default. I can't think of the last time we had a real covenant in one of our deals."

Landry told me about the terms TA Associates secured recently to fund the purchase of a company. In particular, the interest rate was set at 2.25 percent over the floating London Interbank Offered Rate, or LIBOR. But TA Associates doesn't have to make all its payments in cash if the acquired company runs into trouble. It can make something known as a toggle payment, or "payment in kind," essentially borrowing more to make the regularly scheduled loan payment. The only penalty: an interest rate that rises 0.5 percent.

"How do you default?" asks Landry. "You used to say, 'Can I pay down enough of this debt so if a recession hits I can get through it?' Now it doesn't matter even if a recession hits next week."

A relatively new phrase, "covenant lite," describes the lending terms in big private equity transactions. Tom Draper, chairman of the debt financing department at Ropes & Gray, traces that trend back to financing for the 1995 megabuyout of Sunguard Data Systems. "That was a watershed," Draper says. "Now that's trickling down in the middle-market deals."

Private equity executives take as much as they can get from debt markets, but still raise the issue of lending excess in public because it will be bad for business eventually. The cycle of cheap and easy credit drives up the prices of companies they buy and may hurt future investment returns.

Investors stretching for yield are making all kinds of markets do strange things. Look at the subprime mortgage market to see how that practice can end badly. Private equity's debt bubble could become another story with an very ugly ending.

The Red Herring

Old dog, new trick: Boston Capital's brand new blog is up and running. Like the column, the blog focuses on local companies and investment management of all kinds. Stop by to visit: boston.com/business/blog/bostoncap.

Steven Syre is a Globe columnist. He can be reached at syre@globe.com.

(Correction: Because of reporting errors, the Boston Capital column in yesterday's Business section about private-equity debt misspelled the name of Sungard Data Systems Inc. and incorrectly stated the year Sungard was acquired by private investors. The company was purchased in 2005.)

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