Returns May Suffer As Firms Deploy Record Equity

General partners in the first half of 2008 wrote equity checks averaging about 39.3 percent of their total deal cost, or 3.7x EBITDA, according to the ratings agency, which began tracking such information in 1997. The trend picked up steam as the year progressed: Between April and June, equity contributions accounted for 39.9 percent of total deal value, or 3.9x EBITDA.

The previous peak in equity contributions took place in 2003, when credit markets remained tight in the wake of the 9/11 terror attacks, the bursting of the tech bubble and the corporate accounting scandals of Enron and WorldCom. That year buyout pros shelled out an average of 34.8 percent equity per deal, or 2.8x EBITDA, nearly a full-turn of EBITDA less than in the first half of this year.

To buy mid-market companies generating less than $50 million in EBITDA, firms put an average of 41.8 percent and 41.0 percent equity into deals in Q2 and the first half of the year, respectively. For perspective, the full-year high-water mark for U.S. mid-market equity contributions is 2002’s 40.8 percent. Last year’s average mid-market equity contribution was only 32.1 percent.

John O’Neill, Americas director of private equity at Ernst & Young’s Transactions Advisory Services, said he sees 40 percent equity contributions as the new norm, adding that he’s seen equity checks upwards of 50 percent in “a lot” of transactions. “Our clients are telling us they’re managing the expectations of their LP investors, saying that returns will be coming down,” O’Neil said. Firms that once aimed at hitting returns north of 30 percent, he said, are now swinging for the low 20s.

Meantime, purchase price multiples for the overall buyout market remain relatively high. In Q2 2008, the average purchase price multiple for U.S. LBOs stood at 8.9x EBITDA, just shy of the average 9.0x EBITDA average for the first six months of the year, according to the ratings agency. That’s down from 2007’s lofty 9.7x EBITDA, but above the 8.4x EBITDA seen in both 2005 and 2006. Naturally, large companies tend to command higher prices than small companies.

In the middle market, the average purchase price in the first six months of 2008 clocked in at 8.2x EBITDA, more than a full turn less than 2007’s year-end average of 9.3x EBITDA. Meanwhile, the average middle market purchase multiple for Q2 showed a sharp decline to just 6.4x EBITDA, nearly three turns less than the 2007 average. Middle market debt-to-EBITDA multiples for the quarter came in at 3.5x EBITDA, below the first-half average of 4.4x EBITDA.