Private equity firms are having to reduce the leverage in buyouts to get deals done, as the cost of debt has spiraled and banks remain cautious about how much they’ll lend.
(Bloomberg) — Private equity firms are having to reduce the leverage in buyouts to get deals done, as the cost of debt has spiraled and banks remain cautious about how much they’ll lend.
Traditionally, buyout firms would load up the companies they acquire with debt in order to maximize returns, with leverage of six or more times earnings typical in deals before Russia’s invasion of Ukraine rocked global financial markets.
But recent deals have had much less generous financing. A $9.4 billion debt package being lined up to back GTCR’s purchase of a majority stake in Worldpay Inc. — set to be the largest buyout financing in over a year — is expected to be just above 4 times earnings following the transaction. A €500 million ($544 million) financing deal for the buyout of Infra Group by PAI Partners, meanwhile, is the equivalent of around 4.5 times earnings.
The change comes after a series of aggressive interest rate hikes more than doubled debt servicing costs for buyout firms since the start of last year. A JPMorgan Chase & Co. index of European leveraged loans has a current yield of 9.4%, up from around 4.5% at the start of February 2022.
And banks, still reeling from being forced to dump billions in hung debt on deals that soured last year, don’t want to lend as much. They see conservatively-leveraged deals as easier to sell on to institutional investors.
At the same time, valuations for buyout targets remain elevated. “Debt multiples are going down but deals for the highest quality companies are being done at enterprise values that are still high,” according to Michael Dennis, co-head of European credit at Ares Management Corp.
Diverging price expectations, as well as the lower leverage available to buyout firms, have scuppered several deals in recent months. But for those that are going ahead, private equity firms will need to stump up a bigger equity portion.
Other potential buyouts, including UK pharmaceutical business Pharmanovia and Austrian packaging company Constantia Flexibles, may include debt packages of up to five times earnings.
An improvement in credit markets in the future may mean that buyout firms seek to add more debt and remove some of their equity exposure.
“If rates fall or a company grows then there will be more cash headroom, which could mean private equity firms look to renegotiate debt incurrence levels,” Dennis said.
Still, being able to add debt later will require better market conditions, and the cost of debt to come down, which isn’t guaranteed.
Even if interest rates do start to come down, lenders may be cautious after recent turmoil in the financial sector and in the context of a slowing economy. They’re already being tougher in calculating the potential earnings of buyout targets, and that’s unlikely to change as companies face challenges including higher input costs and a consumer-spending crunch.
“We are at a dislocation point in time where there is more equity and less debt than is typically the case in buyout deals,” said Robin Doumar, managing partner of Park Square Capital. “At some point the capital structure of these companies will need to be adjusted.”
–With assistance from Tasos Vossos.
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