With nearly $1 trillion in uninvested capital in their coffers, private equity general partners (GPs) will likely be eager to do deals this year. (Indeed, as noted in our previous post, there is a risk of some firms being overly eager). In addition to the overhang of unused capital, the economic uplift has improved debt market conditions. This too should help put wind into the sails of more PE deals.

As we noted in our recently published Global Private Equity Report 2011, the loosening of lending standards provides evidence that banks will be willing to lend for larger, higher-risk issuers, including PE deals. Banks will be able to syndicate these larger, riskier loans to institutional investors. With interest rates at record lows and expected to remain there well into this year, demand for leveraged loans from yield-hungry institutional investors will continue to be strong. One vibrant source of demand in 2011 is likely to be loan mutual funds. Loan mutual funds took in a record $16 billion in the US during 2010, according to Lipper FMI, driving their share of the institutional demand for new leveraged loans to 14 percent—a five-year high.

One looming barrier, however, is the cliff of leveraged loans and high-yield bonds coming due for refinancing over the next several years (see chart). Despite improving debt-market conditions and company-level progress in leveling the cliff, significant risks remain. These risks could affect banks' and institutional investors' capacity to absorb this growing supply of refinancing and leave enough room to supply companies with net new capital, including the financing of PE deals.
 
Still, the major debt-market improvements will lead to more leverage and easier terms for PE financing. The increase in the amount of leverage that PE investors were able to bring to the financing of LBOs and the softer covenants attached to it in 2010 should continue throughout this year, provided investor demand remains buoyant. Covenant-"lite" loans increased to nearly 10 percent of total leveraged loans issued in the US in the latter part of 2010. In January of this year, their share swelled to 26 percent, on par with what it had been during the 2007 PE boom when fully a quarter of leveraged loans carried less-restrictive covenants.

The cost of debt should remain relatively flat but could face upward pressure. Risk spreads could expand in 2011 as more new issues come to market and the imbalance between already strong demand and increasing supply narrows. LIBOR, the other component in debt cost, is at historic lows and continued loose monetary policy by the US Federal Reserve and other central banks in developed economies is expected to hold it there. However, investors will continue to write LIBOR floors into the loans they buy to compensate them for low lending benchmarks.

Taken together, the improving dynamics of the debt markets will make the economics for LBOs more attractive, which will support increased deal activity in 2011. In the next excerpt of our series, we'll take a close look at the supply side of PE deal-making and the kinds of deals PE funds are looking to make.

This post was written by Graham Elton, Bill Halloran, Hugh MacArthur and Suvir Varma, leaders of Bain & Company's Private Equity Group.