Why would a buyout fund want a lower leverage?
Just had a phone call with a tech MM PE associate, I mentioned 30%-35% debt for tech/consumer business buyout as an example. He said no one uses 30% debt and 40% debt is always better in tech PE, which I agreed because of the regulations reason&tech companies generally have larger multiples hence weaker balance sheet.
He argued it has nothing to do with regulation and because there is no upside for debt investors(banks), and PE wants the upside by paying more in equity. It’s a really confusing point as I believe no matter how many you borrow from a bank, at the end of the day, you own 100% equity when exits. Because of regulation, most of the time, PE couldn’t use leverage too high. Just like you could buy companies with 5% equity investment in 80s and there is no reason any PE wouldn’t do a deal borrowing 99% money if they could. Just my shallow opinion after reading King of Capital. Please advise where I got it wrong.
I think you are fundamentally missing the point here. Why does a PE firm use leverage in a transaction? To boost returns. What happens when you over-lever a Company and can’t meet your debt obligations? You miss principal and interest payments and have to go through forebearance and either out of court or in-court restructuring; at that point private equity firms have to hand over the keys to creditors and the creditors take control of the Company.
Tech companies are interesting because you have two sides of the equation: growth equity / venture type deals and established technology companies. Typical lenders to tech businesses will be cash flow lenders, because there are no hard assets to rely on. Leverage increases your equity returns to a point and after that any incremental leverage decreases your overall returns.
Typical capital structure pre-COVID was 35-40% equity with the balance being debt. Now creditors are requiring 50-60% equity and fill in the gap given the uncertainty in the markets. As you mentioned, creditors have no upside as they only care about the Company making their principal and interest payments (unless they have equity co-invest).
wait are you saying debt as % of transaction size is higher now than pre-COVID? Confused by the wording
EDIT: just saw update, nevermind. thanks!
Yep, apologies if it was confusing. Hopefully that should clear it up for others
Are you saying equity as a % of debt? Usually I see it phrased as equity as % of TEV.
No. It’s debt or equity as a % of total capitalization.
I think you may have flipped debt / equity (at least Pre-COVID). You typically see 35-40% equity contribution, maybe higher these days with COVID. Nothing compared to the percentages pre-08
Yeah if you max out leverage you may have to give on price and flexibility with things like covenants which can be an issue if your business is cyclical or uncertain. If you're absolutely certain your business will perform per projections then by all means, take the debt, but the extra breathing room can help out in the first few years. If things go better than expected, then you can always go out and do a recap.
Another issue, which may be a little controversial, is that there are a lot of funds struggling to put capital to work. They could be incentivized to write slightly larger checks (take less leverage) to show faster deployment and go back to market for their next fund more quickly (in theory before the market cools down). I've never actually seen anyone explicitly do or say this, but it has to be on people's minds.
Lastly, and this is more of a lower MM thing, is that portco managers don't really understand debt in the same way PE people do. If you're buying a business from a founder who plans to roll a significant stake, saying you won't overlever the business is a good selling point even if it's detrimental to cash on cash returns. This may be the case in tech too if you're looking to buy out a growth stage company and keep the founder significantly involved.
Great point here and above. Even though it's not explicitly mentioned, does less high-return opportunities, mainly due to competition, also have an impact here? (30%IRR pre-2008 and now funds struggling to realize a 15%IRR)
Since you mentioned LMM PE. The interesting dynamic in LMM PE is that it's easier to get away with breaching covenants/being late with lenders @ the LMM level because it's much harder to squeeze what they might need out of a smaller co, especially if you're in a business without a lot of tangible assets. Allows you to slap them around a bit, not that you should but hey...
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