The relatively young buyout industry has rarely faced so many challenges as at the present time, as evidenced by the meager volume of transactions completed in 2001. Despite an inflow of more than $60 billion into buyout partnerships in 2000, LBO groups put less than $25 billion to work in 2001, according to Thomson Financial. At industry conferences all across the country, we hear common sentiments:
“Purchase price multiples are too high.”
“The senior debt market has disappeared.”
“There’s no earnings visibility.”
“Mezzanine capital is too expensive.”
“I’m focused on my portfolio right now.”
“In a down economy, there are few quality companies coming to market. The only things we see are distressed situations or divisional spinoffs being sold for strategic reasons.”
Fortunately, as the economy stabilizes, deal activity is starting to pick up, and deal professionals are cautiously optimistic that the worst is behind us. But will we ever return to the days where 40% IRR, 5 times returns were the benchmark by which success was measured?
To better understand how the evolving financing landscape has affected mezzanine and equity rates of return both in an absolute and a relative sense, we created a financial model to quantify returns for “Acme Company,” a hypothetical service or manufacturing company. We evaluated two capital structures; one representative of deals completed in the mid 1990s, which we refer to as our “Mid-’90s LBO,” and one representative of the current environment, which we refer to as our “Current Market LBO.” We then compared equity and mezzanine rates of return assuming a range of five year Ebitda growth rates from (-5%) to 15% per annum. While one might take exception with some of our underlying assumptions, we believe they generally reflect our experience in the marketplace. Directionally, the results help illustrate some of the challenges and dynamics of getting transactions completed in this environment.
Acme Company Assumptions
Acme Company has annual sales of $160 million and a 12.5% operating margin, which produces trailing Ebitda of $20 million. While working capital and capital expenditure characteristics may differ between a service company and a manufacturer, our assumptions can be generally representative of both for a company of this size. In the “Mid-’90s LBO”, Acme Company is acquired for 5.5 times trailing cash flow and sold five years later at an identical multiple. For the “Current Market LBO,” the company is purchased for 5 times trailing cash flow and sold in five years, also at a 5 times multiple. In both cases, transaction and closing costs total $5 million. The capitalization at close is assumed as follows:
Senior debt bears interest at 9%, the mezzanine debt carries a 12% coupon and all excess cash flow after working capital and capital expenditures is applied toward senior debt reduction. In both cases, ownership is allocated 80% to the equity investors, 10% to the mezzanine investors and 10% to management in the form of gifted stock options.
The lack of senior debt financing has minimal impact on mezzanine returns and, in fact, in our model, the “Current Market LBO” produces slightly higher returns than the “Mid-’90s LBO.” This is solely the result of Acme Company having higher free cash flow after debt service in the “Current Market LBO” to more rapidly delever its balance sheet. Also, in the “Current Market LBO,” credit quality for the mezzanine investors has improved as a result of being “higher” in the capital structure with less overall leverage.
Limited senior financing availability dramatically affects equity returns. Whereas a company growing its Ebitda at 15% per annum could produce a return of 42% in the “Mid-’90s LBO,” today that growth rate produces equity results just shy of 30%. The only way five-year returns can revisit a 40% level are through a) earnings growth in excess of 15%, b) multiple arbitrage/expansion, or c) reducing the percent of equity in the capital structure through lower purchase multiples or greater availability of senior financing.
At the margin, conditions may improve, but probably not to the degree necessary for equity returns to rebound to levels seen in the ’90s. We see few basic mid-sized service or manufacturing businesses on which we place a high probability of being able to produce 15%+ earnings growth over the course of a business cycle. The multiple arbitrage strategy relies in large part on a vibrant market for small cap, moderate growth, non-technology company IPOs, which doesn’t exist at present, and over the past 20 years has only been available occasionally. While senior debt availability is starting to improve, especially with the entry of a number of non-bank lending institutions to the marketplace, it will likely never return to mid ’90s levels when it was not uncommon to see capital structures with 5.5 times total debt to trailing Ebitda. We would argue that the extraordinary equity returns realized by many equity investors in the mid ’90s were driven largely by debt investors focused on upfront fees and market share targets that in lending at these levels of leverage in the capital structure were not being adequately compensated in the form of pricing spreads for the risks they were taking. Equity investors were the beneficiaries of this effective subsidy. The ratcheting down of senior and mezzanine lending ratios is a rationale response to having underpriced debt in the past.
The reduced returns in the upside scenario are mitigated slightly by improved downside protection for the “Current Market LBO” as the result of a more conservative capital structure. In the case of a 5% per annum Ebitda decline, equity investors are likely to lose less in the current market environment than what would have occurred in a “Mid-90s LBO,” which had very little margin for error built into its capital structure.
With mezzanine returns holding steady and equity returns moderating as a result of this inability to structure transactions at historical leverage ratios, a pronounced shift in indicative relative returns has occurred. We use the qualifier “indicative” because only time will tell. Some of our industry colleagues are predicting a squeeze on mezzanine returns applied by private equity groups who can successfully reintroduce financing beauty contests for mid-sized sponsored buyouts without discouraging lender interest.
In a scenario of slightly negative to no growth, mezzanine returns, while barely above their contractual yield, are still significantly better than equity returns. Ebitda growth in the 5% to 10% range produces mezzanine returns in the 18% to 20% range – very acceptable results for a mezzanine fund in today’s market. However, these same earnings produce relatively modest returns for the equity investor with IRRs ranging from 14% to 22%. It is only when Ebirda growth starts to exceed 15% per annum that on a relative basis, equity investors are being properly rewarded for the additional risks they are taking. The demand for high Ebitda growth to drive equity returns to acceptable levels highlights the importance of equity sponsors bringing a strong operational/value-added capability to their portfolio. The era of financial engineering alone will not produce the rates of return equity investors have come to expect.
Because most of the mezzanine return is in the form of a contractual interest rate, overall returns are much less sensitive to Ebitda growth. Put another way, Ebitda growth is much less critical for the mezzanine investor than for the equity investor. This can create challenges in getting deals closed and in reaching a consensus on operating strategy.
Most successful mezzanine portfolios are built around hitting singles and doubles with very few strikeouts. Mature businesses growing at or near GNP levels can make for good mezzanine investments. In the mid-’90s, they also generated solid returns for equity investors. Today, they are less likely to produce the returns expected by an equity investor. Conversely, the demands placed on a business to consistently grow its Ebitda at 15%+ may require a level of execution risk (and reinvestment of cash) inappropriate for a mezzanine investor. These may be underperforming turnarounds with significant upside, companies operating in industries experiencing rapid growth and/or change or companies executing an overly aggressive strategy projected to produce earnings growth in excess of industry trends.
Assuming parties come together and close transactions, post-closing tension can occur when the equity sponsor advocates an ambitious growth strategy while the mezzanine investors voice concern over increased execution risk and the fact that most of the incremental gain from successfully executing a riskier high-growth strategy accrues to the benefit of the equity sponsor. Decisions regarding the timing of exit can also be a source of conflict, especially when a control equity sponsor hesitates to exit, hoping for greater future growth in order to realize a targeted rate of return.
While this analysis has been simplified, we can draw some conclusions for mezzanine and private equity investors, investment banking intermediaries and company management teams creating private company capital structures most likely to deliver successful results to each of its constituent parties:
-In any given transaction, there is a fixed amount of investment return to be allocated among the senior debt, mezzanine and equity investors. Supply and demand largely determines how this return gets allocated. In the current environment, a surplus of available equity and shortage of debt financing has shifted the allocation toward debt investors.
-Lower acceptable risk levels for senior cash flow-based leveraged loans has also created more opportunity for mezzanine investors to improve returns while also participating at a higher level in the capital structure. It has also enlarged the overall market for mezzanine capital.
-Private equity sponsors in effect are being required to underwrite a greater proportion of business risk than in the past. Over time, the willingness to do so will increase the availability of mezzanine and senior capital, and returns will shift accordingly. While there could be a potential shortage of mezzanine capital if all of the buyout equity raised over the past few years gets put to work, given the current pace of investment activity, there appears to be plenty of mezzanine capital to support the industry. Mezzanine investors, especially those active in agented private placements of subordinated debt, are under increasing pressure to cut rates to shift returns back to equity sponsors. Equity, in the form of warrants, is a very precious commodity and many equity sponsors prefer to exchange a higher contractual yield in the form of PIK interest in exchange for reduced warrant positions.
-Mezzanine financing can be a compelling financing instrument for good companies that do not present the levels of earnings growth prospects that will be increasingly required by private equity investors to generate top quartile returns for their asset class.
-Opportunities will continue to be few and far between for LBO firms to engage successfully in simple financial arbitrage by buying low and financing mostly with borrowed, cheap, flexible capital. Principal investors who prioritize getting deals financed on terms offering acceptable risk/return relationships to senior and mezzanine investors, respectively, will enjoy success. They can then roll up their sleeves and go to work to earn leading private equity returns by bringing to bear on their portfolio companies real strategic resources and specific asset, technical and industry operating expertise to generate growth in earnings and business values.