Friday Letter Playing with fire

With the US debt ceiling showdown going down to the wire and a possible downgrade of the country’s debt rating on the line, don’t expect America’s fractured, dysfunctional government to find a solution that won’t cast a pall on private equity real estate activity.  

With the deadline for raising the debt ceiling and avoiding an unprecedented default just one weekend and two business days away, America’s fractured, dysfunctional government is no closer to reaching a compromise solution than it was a month ago.

The past week saw Republicans in Congress wrestle amongst themselves with a smaller, temporary fix to the debt ceiling problem. As PERE was writing this letter, Republicans in the House of Representatives were trying for a third straight day to pass a bill their own party could agree on. Meanwhile, Democrats in the Senate were pushing ahead with a larger package of cuts and an increase in the debt ceiling that would carry the US through the 2012 elections. With both parties diametrically opposed to the other’s solution, it appears that this showdown will be going down to the wire.

That uncertainty took its toll this week on US stocks, which were poised to have their worst week in more than a year. More importantly to PERE readers, it is beginning to have an effect on real estate finance, which saw spreads on one CMBS deal widen significantly last week and another deal pulled altogether this week. And according to market observers, it won’t be long before that uncertainty trickles down to the fundraising market and finally to property transactions themselves.

This scenario unfolds just as things had started to look up for private equity real estate. Indeed, the first half of 2011 saw an increase in transactional activity from both buyers and sellers as both sides looked to capitalize on improvements in market fundaments and valuations. That translated into renewed optimism among GPs, who responded by launching a wave of new funds to capture the capital looking to invest in such opportunities. Whether LPs are committing to such offerings, however, is a separate matter of debate. Still, all of this positive momentum is now in danger of coming to a screeching halt.

Regardless of the outcome of the debt ceiling showdown, which most people believe will be resolved without a default, the bigger threat is the possibility of a downgrade in America’s top-tier debt rating, which would increase borrowing costs for the government, companies and consumers. Standard & Poor’s has said it would lower the US’ sovereign debt rating from triple-A to double-A if Congress does not achieve a longer-term hike in the debt ceiling and roughly $4 trillion in spending cuts.

For private equity real estate firms, event risk now becomes a real consideration in a market where such risk previously never needed to be taken into consideration. As one market observer said, “If debt pricing becomes uncertain, equity pricing become difficult and then transaction pricing become difficult. A 50 basis point move can have a profound impact on a $1 billion transaction.”

The solution to this political quagmire is comprise and shared pain. Both Democrats and Republicans need to stop posturing and reach a compromise that raises the debt ceiling through the selection of the next president, as global markets and investors would not be reassured by a drawn-out scenario. More importantly, the deal needs to avoid a potential debt rating downgrade by achieving $4 billion in savings through a combination of significant cuts and lapsed tax breaks and subsidies. Both sides need to swallow their pride and take their medicine for the problem they both helped to create.

That said, I have lost my faith in the US government to do anything but bicker and point fingers. I have little faith that the two parties will achieve a longer-term solution to the debt ceiling problem, let alone a compromise on a significant package of cuts to avoid a ratings downgrade. My advice: prepare for dark days ahead.

Let’s hope I’m wrong.