Private
Equity (PE) transactions are primarily debt financed. They represent up to 25%
of the total M&A. Unlike corporate-strategic buyers (CSB) - they involve
temporary capital structures and temporary ownership. They unlikely go to their
legal final maturity of 7-10 years. They are either refinanced or sold if they
perform well or are restructured if they do not. They reason is their high cost
and limited flexibility based on their high debt levels. They typically have non
investment grade debt ratings in the BB-B range versus CSB investment grade
ratings. This is due to their inverted capital structures which are 30%
equity-70% debt. CSB capital structures are usually investment grade-in the
BBB-A range with 70% equity-30% debt.
PE firms
consider the following when selecting an initial transaction capital structure:
1) Their financial preferences concerning
cost, risk and flexibility. Lower rated firms face higher financing costs and
lower flexibility reflected in covenants and amortization schedules. For
example, currently a BB+ leveraged loan has a prorate spread of LIBOR+ 165B,
while a B+ spread is in the LIBOR+ 265BP range.
2) Financing need: large needs argue for
higher ratings/lower debt levels. The “B” market is smaller and less liquid
than the “BB” segment.
3) Firm specific characteristics
concerning leverage levels, cash flow and size. For example, BB+ firms have
revenues around $3B and debt to EBITDA of 3X while B firm’s revenues are closer
to $1.5B with leverage in the 4.5X+ range.
4) Market conditions: the non investment debt
market is very volatile. The market virtually shut down during the financial
crisis. This causes a real risk when attempting to fund a transaction with a
capital structure designed for a market which has changed. Unlike CSBs- market,
not firm factors are the most important determinants of PE capital structures.
Once they have chosen their rating which reflects their
preference they can then determine their debt capacity as reflected in rating
agency publications. A sample is reflected below:
So for a B+ target and $100 of EBITDA debt capacity is
around $500.This would be fined tuned with cash flow projections to develop the
debt amortization schedule. Of course, the level changes based on market
conditions.
PE prices transactions off of debt capacity compared to CSB
which price off synergies as reflected below:
Assuming an acquisition where the Target’s EBITDA is $100-the
maximum that could be paid with a 25% level of equity injection and 4.5X funded
debt leverage is $600 for 6X PPX. Currently purchase price multiples are 8+
leaving a significant gap. The PE firm’s options include:
1) Decline the
deal: PE firms are, however, under pressure by LPs to invest. Either you invest
the LP’s commitment within an allotted time, usually 5 years, or it expires and
with it the PE firm’s fees and carried interest.
2) Increase the
equity %: this reduces the deal’s IRR.
Deal IRRs below target levels reduce the PE firm’s carried interest.
Additionally, low overall fund returns complicate future PE firm fund raising
efforts. Remember, the deal IRR is the entry equity investment less the exit
entry process upon future sale. Assuming the entry PPX equals the exit PPX and
no interim dividends-then IRR will fall given increased initial equity unless
the target’s EBITDA performance is increased.
3) Reduce the
PPX: unlikely in a competitive bid situation.
4)
Increase leverage by expanding debt capacity: this is
achieved thru financial engineering with products that reduce debt service via
reduced cash interest (PIK) or extended maturities (bullet maturities). Options
include the following:
The availability and cost of the different debt options is
subject to market conditions. The key points are that debt capacity is based on
only two sets of factors- (1) the debtor’s internal operating cash earnings,
EBITDA, and asset collateral values and (2) market conditions which influence
debt service-cash interest expense and debt amortization reflected as (where
the( I +1/n) term is the funded debt multiple (FDX)):
Debt
Capacity= EBITDA/ (i + 1/n)
where i is the average interest rate and n is the
average debt duration.
PE firms, like real estate developers are driven more by the
second part of the equation than the first. This has some interesting
implications:
1) PE target demand is driven by financing not
price. Demand can actually increase as PPXs increase provided FDXs increase.
2)
Both the financing market and target market are volatile,
highly pro-cyclical and amplify each other.
3)
PE fund returns tend to fall for later stage
acquisitions. They continue to over pay and buy late in the cycle, provided
funding availability, and suffer the return consequences later.
4)
Capital markets have accommodated PE firms by
development a suite of debt capacity enhancing products.
5)
PE capital structures are non risk adjusted IRR
driven.
6)
The initial projected IRR range( based on
varying exit EBITDA, PPX and year of exit) is calculated as:
a)
IRR: (Entry Equity) + Exit Equity Yr t/ (1+IRR)
^t=0. The internal rate of return on an investment or project is the
"annualized effective compounded return rate" or "rate of
return" that makes the net present value (NPV as NET*1/(1+IRR)^year) of
all cash flows (both positive-exit equity proceeds- and negative-entry equity
investment) from a particular investment equal to zero.
b)
Entry Equity=EBITDA Yr0 X PPX Yr0 - FDX Yr0 X
EBITDA Yr0. The initial equity investment outflow is equal to the purchase
price defined as trailing EBITDA times the PPX less the amount of debt funding
defined as trailing EBITDA times FDX all at the time of close.
c)
Exit Equity=EBITDA Yr t x PPX Yr t- FD
outstanding Yr t (think of Exit Equity value as terminal value in a traditional
DCF analysis). Expected net equity proceeds upon sale in year t are the
enterprise value purchase price-exit year EBITDA times PPX-less any remaining
outstanding debt.
7)
Viewed in this light PE firms can create value
in later cycle acquisitions with high PPX by:
Increasing EBITDA in year t-this is difficult for later stage deals where
EBITDA margins are already high
Assuming a higher exit sale PPX or earlier exit
Decreased
entry equity from higher initial FDX-the usual choice
PE firms are not stupid or crazy. Rather they have different
incentives than CSBs. Hence they have different capital structures.
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