Banking sector faces serious challenges as it moves into private equity

BANKS look set to become the “reluctant new private equity” as the credit crunch enters its next phase and recession takes hold of the UK economy.

That’s the prediction being made by accountants PricewaterhouseCoopers (PWC) as the end of what has been a truly turbulent year draws near.

The firm warns that with no ability to provide the required leverage to potential buyers of corporate customers in trouble banks will find themselves as reluctant equity holders in businesses as they are forced to convert debt structures to equity.

According to Stuart Warriner, PWC’s Northern head of corporate finance, poor debt liquidity will further impact the pool of potential buyers of a business. Meanwhile, banks will be under severe strain to manage their debt portfolios and safequard value.

“In previous recessions the banking sector was affected at a later stage as the broader economic issues impacted their business models,” he said.

“However, with the credit crunch preceding the current economic downturn the banking sector is already significantly weakened despite the recent actions of governments around the world.”

He continued: “As a result of the banks’ weakened balance sheet positions, they are aiming to reduce lending levels, from those of two years ago, by up to two times EBITDA on their current loan portfolio.

“However, when this is applied to a company in recession and facing reduced profits, there will be a significant funding gap. This is especially the case when considering the high lending multiples in 2005/06 and early 2007. Companies that arranged five year facilities in 2005 will need to consider refinancing in late 2009.

“As companies face financial difficulty, their reduced profit levels will mean that enterprise values could soon be less than the senior debt, with mezzanine and other junior debt wiped out.”

Mr Warriner said normally a company in such a position would breach its covenant creating the start of an insolvency procedure or restructuring. However, he said this is where the old model now began to break down.

“Success in this case is measured by full recovery of senior debt,” he said.

“Furthermore at this stage of the economic cycle, any pre-pack administration will be perceived as a “fire sale” placing further stress on valuation.

“The banks, under pressure to realise value, will be unable to unload their debt positions and will be forced into keeping the company and the management. They will leave the maximum level of debt that they can on the company’s balance sheet and convert the remaining debt into equity.”

He said that questions were being raised as to whether banks are natural owners of such businesses as they will need to create structures to maintain and incentivise management teams.

“At the same time they will most likely have to provide additional funding to support the business through the cycle, or at least until realistic offers for the business can be realised,” he added.

Even the creation of debt funds will not ease the banks’ predicament until there is a positive upswing in market conditions Mr Warriner warns.

“This will place huge pressures on the banking model and on how they can jointly align management and the banks’ interests,” he said.

“We believe this will be the key feature of this recession and will raise significant questions as to how banks behave and corporates perform in key segments of the UK economy.”