Monday, November 16, 2015

Private Equity: Between a Dog and a Fire Hydrant?

S&P Capital IQ-LCD published a report on the largest LBO transactions of 2015. Some interesting observations include:

1)     Purchase Prices (as multiple of EBITDA): increased a full turn in the LTM from 10.25X to 11.24X. This is a new high eclipsing the pre-crisis 2007 record.
2)     Funded Debt (as multiple of EBITDA): relative flat at around 6.5X. Regulatory security has depressed leverage levels.
3)     Equity Levels (as percentage of capitalization): increased to 35% to compensate for higher prices and constrained leverage.
4)     Deal Size: unlike corporate acquirers were the large deals (over $10B) have reached record levels, current LBOs are smaller in size. The largest deal PetSmart is $8.9B. This is partly due to the absence of larger Public-to-Private deals.

This presents a problem for PE. High prices, stagnate leverage and high equity will hamper the IRR performance for current deals. PE is forced to compete against not only corporate strategic acquirers, but also thousands of PE firms flush with newly raised funds. The current level of PE dry powder is $540B and growing. PE firms are being forced to deploy their capital into more expensive deals.
Leverage levels, unlike in previous cycles, are unlikely to loosen anytime soon. Regulators are still concerned with leveraged loan debt levels exceeding 6X EBITDA. The 2015 Shared National Credit report indicates a majority of the special mention credits (i.e. criticized) involve leveraged loans. Specifically concerning to regulators is poor underwriting represented by weak covenants, back-ended repayment terms, reliance on refinancing, and inadequate collateral. It is understandable that banks driven by shrinking net interest rate margins are attracted to higher risk leveraged loans with their higher nominal returns. Underwriting such loans this late in the credit cycle means credit losses are likely to increase-especially in energy and leveraged loans.

All of this leads to lower expected fund returns. You can see this reflected in lower stock prices of public PE firms like KKR and Carlyle. The August and November market corrections could slow corporate strategic acquirers relative to PE. The tightening credit markets, however, will complicate financing terms, pricing and availability. So, as the saying goes, PE may find itself caught between the proverbial dog and a fire hydrant, which means things, can get a little wet.


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