A shift in investors' risk appetites and a move to wider interest-rate spreads may indicate that the availability of "cheap capital" observed in recent years may be "nearing an end or at least taking a pause," according to a recent report by Standard & Poor's New York-based primary-credit analyst William M. Wetreich.

Also, if banks are stuck holding debt on leveraged buyout (LBO) deals they had planned to syndicate, their flexibility to invest in new deals is reduced, thereby shrinking the pool of liquid capital.

One energy private-equity veteran says the word from New York is that debt-dealers have gone on vacation. This is the case with the broad market, but not as much with the energy market, he says; however, the situation does still affect energy companies' access to debt capital right now.

S&P reports that investors' growing risk aversion, and a reduction in capital liquidity, may cause some E&P companies that are seeking financing deals to accept more costly capital or upgrade their credit measures before looking for capital for acquisitions or organic growth.

"Credit measures associated with LBO loan-financed transaction are at their weakest compared with any point over the past decade," Wetreich reports.

For example, the pro forma total debt of all industries (excluding media and telecom) to EBITDA (earnings before interest, taxes, depreciation and amortization), on average, was close to 7.0 times EBITDA in the second quarter of 2007, higher than at any point in the past 10 years, he reports.

As a credit measure, a ratio of such debt at 7.1 times EBITDA approximates a CCC credit rating. A low A or high B median rating is 5.5 times EBITDA. Wetreich says that, as a result of greater debt burdens and weaker credit measures, there is more exposure and increased vulnerability to both market volatility and to less favorable economic or industry-specific conditions.

His report was issued approximately one week before debt markets failed to respond to Federal Reserve Bank measures to push rates to 5.25%. Markets were trading at 6% or so, instead, and the Fed was infusing more below-rate capital to achieve the 5.25% target. The situation was largely a result of defaults on subprime mortgages, and buyers of these mortgages' inability to sell the packages up or at all.

During the past six years, the volume of announced LBOs has more than tripled, Wetreich adds, rising to some 2,454 deals in 2006 from 754 in 2000. That increase, along with greater debt burdens, weaker credit protections, more aggressive financial policies and less favorable credit-market conditions are contributing to a rise in credit risk and a decline in credit quality, he says.

The fact that corporate financial policies have become increasingly aggressive over time may also be cause for concern. Shareholders are becoming more insistent that management return value to them.

When management responds by using debt to fund shareholder-return initiatives, it can adversely impact credit measures and the company's overall financial flexibility, possibly resulting in a rise in credit risk and a decline in credit quality.

Another factor that could hurt E&P companies' credit quality is a weakening economy. If conditions weaken, debt-service requirements become more onerous, and if companies are not able to meet their debt requirements, defaults could occur, although current default rates are very low by historic standards, say Wetreich.

However, if some institutional investors are gun-shy about LBO-induced risk, there are commercial banks that are happy to take up the slack.

"There is currently an aberration in the senior, secured lending market," says Dorothy Marchand, Houston-based senior vice president and lending manager of energy banking for Compass Bank. "About five years ago, it was extremely unusual to see institutions other than banks in the senior, secured debt market. But, since then, investment banks and institutional investors have entered it."

Now, some of those institutions are pulling back, she says, possibly as a reaction to the sub-prime lending dilemma. Within the last few weeks, she has noticed a change in the terms provided on some syndicated credit facilities, sometimes occurring between the time the bank has offered a commitment and the time the deal closed.

"Because some institutional money is pulling back, banks can realize better margins and terms than before on the same risk," she says.

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