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Landmines -- and Treasures -- To Be Found in Credit Markets

9/30/2009 --

Private equity funds need to convince investors to stay on longer to take advantage of coming opportunities, advises Ross alumnus.

ANN ARBOR, Mich. -- The stock market may be on the rebound and corporate earnings on the rise, but the credit crisis is far from over. That means private equity funds need to do some serious planning if they want to cash in on good buys down the line.

That's the reading from Michael Levitt, BBA '80/JD '82, founder and chairman of New York-based Stone Tower Capital LLC, one of the largest investment firms in the credit market with about $40 billion in assets. That market was roiled by the subprime crisis, the crash of asset-backed securities, and the failure of major firms like Lehman Brothers.

Levitt delivered the keynote address at the Michigan Private Equity Conference, hosted Sept. 25 by the Samuel Zell & Robert H. Lurie Institute for Entrepreneurial Studies and the Center for Venture Capital and Private Equity Finance at Ross. He painted a picture of a near future filled with turbulence, but also full of opportunities.

Levitt warned that the current uptick might lull some players into a false sense of security, since corporate earnings are buoyed mostly by cost cuts and not revenue increases. Meanwhile, investors are overcommitted and cash-constrained while banks are pulling back on lending.

For the private equity world, that means a severe drop in deals and the inability to use leverage to make a good return. Deals are being done with much more equity than in the past, he noted.

"Despite what everybody is saying, I think there are some real issues with the economy," Levitt said. "I don't think we're out of the woods."

Right now, the smart firms are weathering the storm. Anybody who can refinance and extend maturities is doing so. The high-yield market is growing, but that is mostly funding refinancing deals. Companies are issuing bonds to get rid of secured loans with covenants.

The real tension, however, will come in a few years, Levitt projected. When credit markets were frothy and banks eager to issue loans, they did so without setting strict covenants, such as EBITDA requirements. From 2012 to 2014, many of those covenant-light loans are coming due, and they're not candidates for refinancing.

"A lot of it is going to default," Levitt said.

That will create value opportunities for private equity buyers -- but there's a snag. The problem is that the investor commitment period for many private equity funds expires just before those defaults will occur.

Private equity funds are going to have to work with their investors and convince them to stay on to take advantage of a huge opportunity, said Levitt.

"That's the conversation I'm having with state pension funds," he said. "The money expires in two to three years and the good opportunities will be in two to five years. Most investment funds, when they get close to the expiration period, they draw the capital. That might not be the right decision. The right decision would be to extend that period."

Banks also face risk on a pile of corporate real estate debt coming due. The corporate loans weren't a problem for the banks -- it was the asset-backed securities that got them in trouble -- and won't be a problem because that debt has been bought up in the market. But the corporate real estate debt hasn't been as widely syndicated.

Hopefully, the market will be smarter going forward, Levitt said. The crisis has taught some valuable lessons about sticking with what you know. It also injected a needed dose of skepticism, he noted. Stone Tower Capital has taken over the management of several broken SIVs and CDOs.

"The fact is that probably 95 percent of people in the structured credit market didn't understand what they were investing in and they didn't understand the risk," Levitt said. "Fundamentally, there were a whole lot of folks investing in stuff they didn't know. I think we've all become much more skeptical. I think we all trust our gut a little bit more. I think a lot of people in their gut said, 'I don't get it.' Invest in what you know. A lot of people just did what others did because they saw them making money. You never want to get caught in that."

So, overall, Levitt is bullish that smart investors and private equity funds can come out on top while the market goes through more shakeouts.

"Turbulence creates opportunity," he said. "The wave of maturities coming creates opportunity. I really believe the next five to seven years are going to be the best time to invest in these sorts of markets that I've ever seen."

—Terry Kosdrosky



For more information, contact:
Bernie DeGroat, (734) 936-1015 or 647-1847, bernied@umich.edu