Tuesday, November 12, 2013

Determining Buyout Capital Structures

My prior post on Capital Structure focused on how traditional corporations establish their capital structures. This entry shifts to how highly leveraged buyout capital structures are determined. Little explanation on how private equity funds set leverage levels for their portfolio companies exists despite buyouts composing an important segment of the overall M&A deal market. As previously discussed, corporation capital structures are ratings based and tend to be permanent in nature. The ratings are tied to fundamentals including size, funded debt to EBITDA and interest coverage.

Buyouts have transitory capital structures driven by factors unrelated to corporations with their more permanent capital structures. Buyouts focus more on maximizing debt capacity utilization tied to market conditions. Hence, their capital structures are highly pro cyclical and drive buyout pricing levels.  (See  Buyout Leverage.)  This is based on the limited life of private equity funds (5 year investment period and 10 year overall life) and the compensation of the general partners (GP).

The traditional GP compensation structure is known as ”2 and 20”. This means they receive a 2% management fee on the funds committed by limited partners (LP) during the investment period, and dropping to 1% for the remainder of the fund’s life. Additionally, they receive 20% of the fund’s profits (AKA the carried interest) after a guaranteed minimum return to the LP-usually 8%. The option like carry is not risk adjusted. Like all options its value is positively related to risk. This leads to a GP-LP agency (conflict of interest) problem. GP are incented to take value destroying investments that cover the preferred return requirement, but not the investment’s cost of capital, to maximize their carry. They are further incented to take as much leverage as the market will allow to enhance their carry. The “great moderation” from the mid 1980s thru 2006 (see Moderation) with its falling rates, increasing profits and high exit multiples shrouded the real effects of these facts from many LPs. The facts became evident once the financial crisis occurred and devastated many buyouts and funds.

The evidence indicates that buyout volume, leverage and purchase prices are inversely related to the spread on high yield securities less LIBOR. (see Drivers) Thus, as markets peaked in the 2006-2007 period, debt spreads fell and buyout leverage surged. Once spreads widened during the 2008-2011 crisis, leverage levels collapsed. Currently, the QE based market recovery has lowered spreads to pre crisis levels. Predictably, buyout leverage levels are approaching pre crisis levels.

The standard corporate explanations for capital structures (trade-off and pecking order) have limited ability to explain buyout leverage levels. Buyout capital structures appear to be based more on market timing and agency factors. The unique contractual organizational structure of private equity funds compared to corporations influences the way they raise capital. This is another area where capital structure theory and practice seems to have a divide that needs closing.


PS We are approaching the next offering of our Acquisition Finance Course in Amsterdam and that also means approaching the deadline to sign up.

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