Looking Back: When Leverage Was King

The math isn’t too complicated. When debt’s cheap and plentiful, sponsors don’t have to cough up as much equity when buying a company. When debt goes scarce and becomes expensive, equity commitments consequently rise.

For an illustration, let’s look back 15 years, to the July 26, 1993, edition of Buyouts. The magazine reported that two affiliates of Texas billionaire Robert Bass were negotiating a $1.1 billion deal to buy a European food company, and that the deal was going to require no more than 15 percent equity and possibly as little as 10 percent.

The deal, it turns out, was part of a larger equity-shrinking, debt-increasing trend. And that trend was fueled by the wide availability of junk bonds. “There’s no question that as the high-yield markets have strengthened, the equity in deals has decreased,” a source close to the Bass deal told Buyouts at the time.

Over the course of the preceding 12 months, Buyouts reported, average equity commitments fell from about 30 percent to 15 percent. And for buyout pros at the time, that brought back memories of the late 1980s, when a sea of junk bonds made 15 percent equity checks standard-operating procedure. “All of the banks have woken up again—with a vengeance,” said Larry Schloss, then of DLJ Merchant Banking Partners and now of Diamond Castle Holdings.

It’s also reminiscent of the most recent buyout boom, when a bevy of new debt providers and holders (hedge funds, CLOs) competed with banks to make possible all kinds of low-cost, borrower-friendly debt instruments, like second-lien loans, as well as more standard senior credit and high-yield bonds. Equity levels fell to lows again in 2006 and the first half of 2007. Apollo Management, for instance, may actually pull off the feat of buying chemical company Hunstman without using any equity at all. (That deal is now in court, however.)

That deal aside, what’s considered a low equity commitment today—in the 30 percent range—was considered high 15 years ago, suggesting that over the long term equity commitments tend to rise. And now that the debt markets have seized up (high-yield issuance for the first half of 2008 was the lowest since 1991), equity commitments have moved to about 50 percent of most deals. What will the next cycle bring?