How Not To Invest in P.E. 101
Updated: Nov 11, 2019
This WSJ article caught our attention as an example of what not to do in private equity or private investing in general. Yet so many take the risk and do it anyway.
There is a Better Way!
Risky Deals Return to Leveraged-Buyout Market
Four years after a government crackdown on the leveraged-buyout market, risky loans are making a comeback. Nearly 13% of LBOs in the first nine months of 2018 were financed with debt equating to at least seven times the target company’s earnings before interest, taxes, depreciation and amortization, or Ebitda, according to S&P Global Market Intelligence’s LCD. That is more than double the level in all of last year and is on track to be the highest since 2014, when 13.5% of deals crossed that threshold and regulators began to crack down on leverage exceeding six times Ebitda.
In another sign of growing risk, the amount of cash private-equity firms are putting into buyouts is falling. Their average equity contribution was 39.6% in the first nine months, also the lowest since 2014.
In a typical LBO, a buyout firm acquires a company mainly with borrowed money, with a goal of selling it later at a profit. The jump in deals that carry extra amounts of debt comes amid a surging economy and generally buoyant financial markets, which have fueled risk appetite, and as Washington takes a less aggressive approach to regulating Wall Street.
It is a big change from just a few years ago. In 2014, regulators brought the hammer down on banks stepping outside federal guidelines for underwriting leveraged loans—shorthand for borrowings by highly indebted companies. Those guidelines had been put in place in 2013 to curb excessive risk taking in the wake of the financial crisis.
Among other things, they discouraged banks from participating in takeovers in which debt is above six times Ebitda, a common proxy for cash flow. When banks didn’t follow regulatory guidelines, they sometimes got slapped with warnings, as Credit Suisse Group AG did in 2014.
The Federal Reserve and the Office of the Comptroller of the Currency, the two key federal agencies overseeing bank lending, had struck a more sanguine tone since President Trump was elected and began to dismantle a number of Obama-era regulations—though that may be changing. “That market has evolved really significantly since before the crisis,” Federal Reserve Chairman Jerome Powell said at a press conference last month. “The banks take much less risk than they used to,” he said, adding that they hold far fewer loans on their balance sheets than they once did. His counterpart, Comptroller Joseph Otting, said at a Washington luncheon last week that nonbank lenders are taking more risks. “Banks have really kind of stayed on the rails,” Mr. Otting said.
But on Wednesday after The Wall Street Journal published a story on the increase in highly leveraged deals, the Fed signaled growing concern, taking the unusual step of releasing remarks by a staffer to a private industry conference. “There may be material loosening of terms and weaknesses in risk management of the leveraged-loan market,” Todd Vermilyea, a senior associate director in the Fed’s regulatory division, said to the Loan Syndications and Trading Association in New York. ”Some institutions could be taking on risk without the appropriate mitigating controls.” He said the Fed is taking a closer look at risk-management practices, including how borrowers’ future earnings are calculated.
Some industry officials point to a ruling last year by a government auditor that called the legitimacy of the lending guidelines into question, and said the Fed and the comptroller’s office didn’t follow the proper legal process for establishing them. The auditor’s ruling “makes it much harder” for regulators to question banks’ lending practices, former Comptroller Thomas Curry said in an interview.
Bankers say regulators are now less focused on a borrower’s precise leverage and are more concerned with the general health of the company and banks’ overall “safety and soundness.”
The bankers and buyout-firm officials add that many of the deals with higher borrowing levels involve strong companies in more stable sectors such as health care and software. Meanwhile, the appetite for debt among yield-starved investors remains ravenous, enabling banks to quickly parcel out the loans to others who then assume the risk.
Still, more heavily indebted LBOs could spell trouble down the line. “For the banks to compete, they need to play ball,” said Meghan Neenan, a managing director at Fitch Ratings. “Is it concerning? Absolutely.”
Whatever the cause, banks have been feeling freer to do deals they would have shied away from just a year ago, bankers and private-equity executives say. KKR & Co.’s $5.6 billion buyout of Envision Healthcare Corp., which closed this month, is among the most highly indebted of the big buyouts this year, with borrowings of over seven times Ebitda. At least eight regulated banks, including Citigroup Inc.,Credit Suisse and Morgan Stanley, helped finance the deal. A banker at one of the lenders said he wouldn’t have done the deal a year earlier.
Figures for 2018 are still far from their precrisis peak. In 2007, more than 23% of buyouts had a debt-to-Ebitda ratio above seven times, and the average equity contribution was just 30.9%, LCD data show.
But there have been other signs of froth that are reminiscent of the precrisis heyday of LBOs. Terms on loans known as covenants have weakened, eliminating protections for creditors in the event a company’s performance takes a turn for the worse. Private-equity firms also appear to be returning to their precrisis habit of teaming up with each other to bid for big companies.
In one example, Blackstone Group LP, Carlyle Group LP and Onex Corp.have joined Canada Pension Plan Investment Board in a bid forArconic Inc. that would exceed $10 billion, excluding the aircraft-parts maker’s hefty debt load, according to people familiar with the matter.
These so-called club deals enable private-equity firms to hunt bigger targets but often lead to disagreement about strategy among the owners, and that contributed to the failure of many of the big precrisis buyouts, like Toys “R” Us.
Borrowers are also making bigger adjustments to expected cash flows to account for cost savings and revenue growth than they were before the crisis, according to research firm Covenant Review. That has the effect of making leverage look lower.
By Miriam Gottfried and Ryan Tracy
Appeared in the October 25, 2018, WSJ print edition as 'Risk Returning to Leveraged Buyouts.'