The LBO market remains strong when profitability is high, private equity multiples are modest, the real cost of debt is low and the risk appetite still remains to buy the debt. The latter is most definitely missing and the question burning on everyone’s lips is when will the market recover? But while the market recovers there are going to be some private equity firms who have just raised funds ready to invest rubbing their hands with glee at the prospect of picking up some bargains in a down market.
The market for distressed and turnaround players is starting to pick up speed and lawyers are already receiving new instructions from turnaround funds. The presence of these players should also boost returns for the period as returns in the distressed market are generally significantly higher than the traditional buyout houses. Turnaround specialists want to make at least six times their money, while the traditional buyout houses of this world, in particular those involved in large syndicates, will settle for two times.
Daljit Singh, partner at
Children of the 80s
Many professionals are drawing comparisons with the last great LBO boom and subsequent bust of the 1980s. But there are marked differences with the crunch of then and the crunch of now. James Stewart of mid-market firm
Stefan Hepp of
Graham Olive, head of leveraged finance for Northern Europe of French investment bank
The same happened with funds that were launched during 2001 after the telecoms downturn, which was also default driven, when purchase prices were low and consequently those funds have performed fantastically well.
So a fund that was launched in the 1990s buying businesses for a pound is going to generate a much higher return than a fund that has bought businesses in, say, 1985 at high prices during the peak. According to data from Thomson Financial, cumulative IRR since inception for European private equity funds with vintage years of 1986, 1987 and 1988 reached 12% for the top quartile; for 1989, 1990 and 1991 it was 17% and for 1992,1993 and 1994 it reached 23%.
And so on a positive note for private equity firms, looking at the above-average returns of funds launched with vintage years between the downturn of 1989 and 1994, funds raised in 2007 by firms such as Carlyle, Cinven, Doughty Hanson, KKR, Providence Equity and Terra Firma Capital Partners should be set for some stellar returns if they invest wisely.
It is those firms attempting to exit now who are going to hit harder times. Stefan Hepp of SCM Strategic Capital Management, says: “Sellers are sticky – they want to wait to see a recovery to get a good price and buyers want to buy now as it’s cheaper so you have a stand-off.” This is going to lead to a decline of transaction volumes across the entire buyout industry, not just large buyouts. At the same time, the increased cost of leverage finance will make recapitalisations more expensive. This will lead to a slow-down in distributions, particularly in Europe where refinancings have been a major source of distributions.
Hepp adds: “At the same time one might expect that the IPO markets will become less receptive, which should affect distributions from venture capital funds as venture-backed IPOs accounted for a lot of the increase in distributions seen recently.”
Ed Eyerman at
Graham Olive at Natixis acknowledges that there is a liquidity-driven problem, but stresses that the backlash is not going to be as severe this time round because the global economic fundamentals are more positive. “Despite the risk that sustained credit illiquidity will curtail the current robust growth rates, the economic pressure on sponsor-owned companies is much lower than in the previous downturns,” he says.
The other big difference is the debt overhang, adds Olive, because the market downturn has primarily affected a different type of debt instrument. “Last time it was driven by the collapse of the high yield bond market and borrowers were forced to revert to traditional debt finance. This time round the downturn is driven by negative institutional investor sentiment in the senior debt market. Banks have to commit themselves to senior debt earlier on in the transaction lifespan so most deals that come to market are several months old. High yield operates in a more real-time window – so this time the longer lead-time with senior debt has created a back-log.”
Mid-market takes the stage
The debt markets are not closed to all. The leveraged debt market remains open for borrowers who can demonstrate a solid business case, do not seek excessive leverage and are prepared to pay sensible prices for their debt facilities.
Most banks still claim to be open for business, although, according to Mike Barnes, a director at advisory firm Hawkpoint, some are more hesitant due to the sheer volume of unsold loans on their books. As a counter to this, some newer entrants to the mid-market leveraged debt arena are taking the opportunity to try to gain share while the market leaders are taking a back seat.
James Stewart of ECI says: “At the mid-market level, it’s business as usual. Banks still remain keen to consider mid-market opportunities and in addition to that there are a number of banks who, up until now, have relied on secondary positions on large leverage deals and who now have experience in private equity and are now looking to move to fund debt in mid-market transactions which they perceive as less risky and consequently more attractive.”
The general view is that new jumbo leveraged deals with enterprise values of more than £1.5bn will remain difficult for the rest of this year while banks clear the backlog of existing transactions. But where a borrower can present a compelling case, even deals requiring debt of up to £1bn may still be done, although more likely on a club basis with four or more underwriters. At the smaller end of the mid-market for deals requiring debt of £50 to £200m, the market is already starting to reopen with deals such as Hutton Collins’ refinancing of home improvement company
Banks are inevitably going to be more selective about sectors. Deals in obviously cyclical sectors such as retail, or those exposed to the housing or construction markets, for example, will probably struggle unless leverage multiples are conservative. It is the traditionally popular sectors like healthcare, media, food & beverage and leisure which should be the first to recover.
Stefan Hepp of SCM Strategic Capital Management sees the current climate as part of the natural cycle of private equity, where the pricing of leverage finance is reverting to its mean, resulting in widening spreads. He says: “As long as the economies grow, private equity is not in a crisis. The overall consequence will be that the number of deals in the second half of the year will be significantly lower as the cost of doing deals has gone up and marginal deals in the pipeline might not get done. But we may actually get a rebound if the debt markets stabilise at their current levels. We are going from a hot temperature of 35 degrees to 28 degrees and there is no need to talk about the beginning of an ice-age.”