The private equity industry is driving towards a big wall. The wall has been pushed back somewhat, and it may yet shrink before the impact takes place, but the collision will come at some point and there will be damage.
The wall in question is the oft-quoted metaphor for the “wall” of loan maturities due in increasing volumes over the next several years. Overleverage is a general ailment across the global economy, but private equity has its own specific case. According to data from Standard & Poor’s LCD (see chart), financial sponsor-backed leveraged loan maturities in the US alone will grow to nearly $140 billion in 2014 after rising steeply from $1.8 billion in 2010.
Some of these maturities will be refinanced, pushed back or remedied by injections of equity. But finance experts worry that the sheer amount of LBO debt coming due means that the market will be unable to absorb all of it. As a result, “many private equity sponsors will be hard-pressed to meet the financial challenges within their portfolios,” says Michael Cerminaro, managing director at New York-based Sound Harbor Partners, a capital markets specialist.
Sameer Khambadkone, a director at New York-based turnaround consultant Loughlin Meghji + Company, puts it more starkly: “There will be a big bucket of deals that do not deliver in time and will face default. There will be difficult discussions leading up to those potential defaults.”
This day of reckoning for LBO firms has been diminished and pushed away somewhat by fortuitous recent developments in the high yield bond markets. Cerminaro estimates that some $180.7 billion in high yield bonds were issued last year, and this allowed some LBO debt to be refinanced. But “we would need to see last year’s record issuance double and extend every year of the next half decade” in order to address the coming wall. Adds Cerminaro: “This is not reasonable to expect.”
Cerminaro notes that the drying up of the collateralised loan obligation market and weakening of the traditional lenders, combined with a broader mountain of leveraged loans and commercial real estate debt, means that there simply will not be enough capacity to refinance every LBO loan coming due. Compounding the problem, says Khambadkone, is the fact that “a lot of these companies have not had EBITDA growth. So the amount of time they have to grow their way to a reasonable capital structure has been crunched significantly”.
The equity markets, including the private equity market, will likely be key in helping to divert disaster. If IPOs pick up, any private equity backed company that can go public will go public, injecting much needed equity into the capital structures.
Many private equity firms, and LPs as well, are currently in discussions with other GP groups about co-investing in existing portfolio companies, helping them create balance sheets more appropriate to the changed market. As the wall gets closer, GPs under pressure will be willing to accept more and more significant dilutions in exchange for life-saving cash.
Some GPs see a silver lining amid the debt gloom. As one fund of funds executive puts it, although “everybody’s got a few problem children” in their portfolio, the restructuring and reengineering that has been required as a response to debt obligations has left many portfolio companies leaner and meaner. It has forced many sponsor-backed companies to make tough choices that robust trading would not have inspired.