Monday, June 2, 2014

Fantasy Finance: Funding the Fully Priced Deal

Private equity firms are facing increasing deal multiples. EBITDA purchase price multiples now exceed 9X-almost equal to the pre crisis 2007 level of 9.5X. Some factors underlying the increase include:

1)   Return of strategic buyers: corporate buyers have returned with M&A volumes continuing to climb.
2)   Rich IPO prices: sellers can point to higher IPO prices as a credible alternative to a buyout, which buyers must match.
3)   Dry powder: PE firms have raised $95B in 1Q14.This is the highest amount since the heady pre-crisis days. Consequently, the fund raising tail will once again wag the PE dog as the money needs to be invested.
4)   Recaps: sellers can obtain interim liquidity thru a recap in the wide open debt markets.
5)   Strong stock market: sellers feel they can wait. This reduces the current availability of targets.

Not surprisingly, debt markets have responded with increased appetite for leverage to support increased buyer funding needs. Debt multiples have risen to over 5.6X EBITDA. This compares to the pre-crisis peak of 6.1X. Perhaps more important, the percentage of deals with funded debt multiples greater than 6X is 40% versus pre-crisis 50% level. This is important as U.S banking regulators have expressed concern over the growth of highly leveraged transactions exceeding 6X leverage. This could damper further bank funded leverage increases.

The current back-of-the- envelope funding gap, PPX of 9 less a debt capacity multiple of 6, now exceeds 3X EBITDA. As the London subway signs state-mind the gap. PE funds are attempting to mind the gap in the following ways:

1)   Operating improvements to increase EBITDA: there are credibility issues on size of improvements. There has to be some strategic basis to the expertise the PE firm brings other than just money. Pay particular attention to pro-forma deals which translate into EBITDA without the bad stuff.
2)   Asset sales: these can be tricky. The market can dry up. Thus, a bridge facility is needed. Also, the sale EBITDA X must be greater than the deal’s PPX. Otherwise, the EBITDA stream will be diluted and remaining debt capacity will decrease.
3)   Assuming your takeout multiple will exceed the purchase multiple. This is questionable given today’s high PPXs. Typically you need to fundamentally improve the target to justify a higher exit multiple, which gets back to point 1 above.
4)   Increase debt capacity thru financial engineering - but we may be reaching a limit at least for banking regulators.

We are approaching the fantasy finance stage in deal pricing as reflected below:

PE funds will continue to be funded by yield hungry investors into the stupid state. Nonetheless, just because you can do something does not mean you should. These types of situations usually do not end well for LPs as reflected in my wheel of misfortunate:

We appear to be in the “capital chasing deals” stage. Like riding a tiger, it is difficult to get off. As noted before in MergerProf the single biggest inhibitor of PE fund returns is overpaying for portfolio investments. This means paying a premium of 40%+ over the target’s pre-bid price. Compensating with an aggressive capital structure from an accommodating debt market further reduces the chances of success.


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