General partners may be leaning too much on leverage finance as they push to close transactions, according to a report from S&P Capital IQ.
Leverage levels are approaching those last seen just before the global financial crisis, says the study, Why the Recent Crop of Leveraged Buyouts Faces Mounting Credit Risk. It found that the debt to EBITDA multiple, pro forma, for LBO deals was 5.7x in 2014 and 5.6x in the first nine months of this year – they reached a peak of 6.1x in 2007.
“What we’re seeing today is very high purchase price multiples of companies because of the credit market and extremely low interest rates,” says Z Capital president and chief executive Jim Zenni. “It fuels the purchase price upward because they can finance it; that is all true of the large, broadly syndicated loan market.”
S&P’s report concludes that too much leverage expands credit risk and creates concern for lenders if the markets falter.
“This is a concern in private equity; it should have been a concern all along,” says Brendan Tyne, managing director of fund administrator Augentius. “I understand it’s necessary to enhance the performance of underlying portfolio companies but, if not done prudently, I think it’s very risky; it’s what actually got us into the mess in the first place several years ago.”
Credit metrics on new LBOs are at their weakest levels since the three years leading up to the financial crisis of 2008, S&P says, and the post-crisis regulation on banks has led to the emergence of alternative, non-bank lenders.
“Banks have not been lending at the levels of pre-crisis times,” Tyne says, citing regulations that place limits on their ability to lend. “There are non-traditional sources of lending out there separate from banks; funds are getting into the lending business and there are other ways to go about it.”
The lending market depends on fund performance. If private equity performance levels decline in the near future, debt-to-equity ratios may fall, says Tyne, adding that high levels of lending directly relates to confidence in private equity returns.
“Things are still good out there; companies seem to be performing well,” he says. “I wouldn’t say people are scared yet. The mood is often more important than fundamentals and lenders are quite hopeful.”
The anticipation of the US Federal Reserve raising interest rates from near-zero levels, however, may not cause much change. Sulaski says, even with an increase, rates will still be near historical lows and will not have much of an impact on people’s behaviour.
At the same time, he recognises the implications of high debt levels in buyouts: “We’ve had quite a run that lasted for 20 consecutive quarters. When we’ve seen lending at these leverage multiples, great companies endure, good companies are fine but some companies struggle because of the heavy debt burden; it’s the inevitable fact of life.”
Both Tyne and Sulaski believe the meltdown of 2008 is unlikely to be repeated any time soon. Lenders have learned their lesson, so it’s unlikely we’ll see levels of leverage from 2005-07, says Tyne.
“It’ll just be part of a more normal cycle,” adds Sulaski. “At 5-6-7x the earnings it will cause companies some heartache but we won’t see anything quite like .”