M&A:Cheap debt and investor appetite for high returns saw record levels of funds flooding into private equity houses this year, writes Caroline Madden

Critics label them barbarians at the gate, corporate raiders, gluttons and locusts. Admirers insist they provide a vital source of finance for companies with growth potential. Either way, there is no denying that private equity investors thrived in 2006.

The availability of cheap debt combined with growing investor appetite for greater returns saw record levels of funds flooding into private equity houses around the globe this year, which in turn fuelled a flurry of takeovers and deal-making.

However, the explosive growth in private equity activity seen of late has caused alarm bells to start ringing in certain quarters. Fears are beginning to surface that the market is displaying classic symptoms of an investment bubble about to burst.

Some, such as the Financial Services Authority (FSA) in the UK, have expressed concern at the "excessive leveraging" used by private equity firms in leveraged buyouts. "The amount of credit that lenders are willing to extend on private equity transactions has risen substantially," the FSA said in a recent publication.

"Given current leverage levels . . . the default of a large private equity-backed company or a cluster of smaller private equity-backed companies seems inevitable."

In a report on global debt published this month, Donal O'Mahony of Davy Stockbrokers highlighted warnings issued by credit rating agencies of "raised default risks stemming from private equity ownership".

For example, rating agency Standard & Poors commented lately that the market had become overheated. "We will see an increase in defaults in the second half of 2007, which could spike up even more the following year," S&P predicted.

In its latest barometer report, the European Private Equity and Venture Capital Association outlined concerns expressed by its members in relation to further interest rate hikes "which might trigger a high profile default by a private equity financed company".

Few, however, are as emphatic as Warren Buffett in their dislike of buyout firms.

Buffett, the second richest man in the world, reportedly commented at this year's agm of his investment company Berkshire Hathaway that whenever he receives calls from "deal flippers", he hangs up on them, as they do nothing to create value.

How does all this fit into an Irish context? Donal O'Connell, senior manager at IBI Corporate Finance, says that almost all Irish transactions exceeding the €20 million mark would attract private equity interest.

While there is a small number of indigenous private equity houses, when Irish corporate assets are up for grabs, British and occasionally US investment vehicles start circling.

O'Connell has observed a marked shift in the market in recent times.

"The traditional idea with private equity is that you would buy a company that would have room for improvement, make those improvements and effectively then sell it on [ for a higher multiple] after a period of time," he says. "That was the traditional private equity 'twist'.

"Now with the level of private and indeed the level of trade buyers that are out there, they're forced to pay a lot higher prices for assets so quite a bit of their return now comes from the level of leverage they will have in the asset," he adds.

"So now they are effectively making more of their 'twist' from the leveraged effect, rather than from an operational effect."

The golden rule now for buyout firms is a strong management team in the target company.

The level of leveraging has been pumped up and up in recent years, although O'Connell observed a "slight plateau" in the final quarter of 2006.

Similarly the acquisition multiple - the ratio of the amount paid for the company compared to its ebitda (effectively the company's cash flow) - has risen significantly globally. In the early years of the decade, the average acquisition multiple across all sectors was seven. The average now stands at a multiple of nine, the highest level in a decade.

So has the private equity market topped out? O'Connell says there is certainly a view that private equity firms in Europe are "paying full prices for assets".

However the buyout bull-run is expected to continue for some time yet in Ireland.

IBI expects that in 2007, any deals above the €25 million mark will most likely attract private equity attention, he says. "Certainly for any of the deals above €100 million, private equity will absolutely be at the table."

The reasoning behind this is that European private equity houses have raised such huge amounts of funds that a lot of this money is still looking for a home.

"We certainly would be of the view that over the next 12 months, private equity will be increasingly involved in transactions here, simply because there's so much money to spend," O'Connell says.

In certain cases, buyout vehicles are using "super leveraging", by piling on mezzanine finance or PIK (payment in kind) notes on top of bank debt in order to bridge financing gaps.

Jean-Claude Trichet has been getting jittery lately about the "under-pricing of risks in general in the financial markets", but O'Connell says that predictions of a wave of defaults in private equity-backed companies if interest rates rise further is very much a worst case scenario.

"Private equity firms aren't reckless in terms of taking risks on interest rates," he says. "It's all part of risk management and that's something that would be looked at very carefully."