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.

J

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Setting a Capital Structure: The Great Divide

There is a great divide between academics and practioners on how to set a capital structure. Modigliani and Miller (MM) proved capital structure is irrelevant under a set of restrictive assumptions. Once those restrictions are relaxed, especially taxes, capital structure can have a major value impact. Academics have focused on the tax benefits of debt, thru the interest tax shield, to emphasize tax considerations in the setting of optimal firm capital structures Trade-Off Theory . An alternative information asymmetry based Pecking Order Theory also exists.

In practice, taxes have a much lower impact on capital structure decisions than theory would suggest-except for extreme cases (e.g. firms with little or no debt like Apple). In fact, while there is little opportunity to create value thru capital structure, there is the likelihood of destroying value given wrong capital structure decisions-especially having too much debt. Both of the main theories are unfortunately silent on how to determine precise capital structures.

Chief financial officers (CFO) are concerned with effective, not optimal capital structures. This means one which supports the firm’s financial strategy (e.g. dividends, flexibility and control). They are uninterested in minimizing their weighted average cost of capital (WACC).  Rather, they seek to preserve financial flexibility to fund their business plan under a variety of market conditions. This is expressed in their target debt rating from the major agencies including Moodys, S&P and Fitch Survey. Ratings are the language of capital structure just like the price-earnings ratio is the summary statistic for valuation. Ratings incorporate cost (debt spreads), availability (the non-investment grade market is smaller than the investment grade market) and terms (covenants) considerations that dominates other explanations of capital structure.

The ratings based capital structure approach used by most corporate (non Private Equity excluded and the subject of a subsequent post) involves the following:

1)     Ratings Factors: major considerations include firm size, industry and financial characteristics including fixed charge coverage (EBITDA/Interest) and funded debt ratio (FD/EBITDA).

2)     Target Rating: most nonfinancial firms chose a moderate investment grade rating between BBB+ and A-.This provides a balance between flexibility and cost. The target should be based on thru the cycle not just point in time considerations. The final decision is usually one for the board and should be periodically reviewed.

3)     Comparative Peer Credit Analysis: spread peers based on their existing ratings and financial characteristics. Focus on peers with your desired rating to determine your required financial ratios. For example, currently, A rated firms have interest coverage ratios of 3X or above and FD ratios below 3X.

4)     Testing: test against projections to ensure debt servicing ability.

This approach is equally applicable for smaller and private firms which do not plan on obtaining a public rating. Such firms should keep in mind that larger syndicated bank loans will be rated.

I am not criticizing the academic approach. Rather, I am pointing out a disconnect between theory and practice.

More to follow.

J

(Don't forget the upcoming Acquisition Finance Course in Amsterdam.)