Is The Private Equity Golden Era Over?
Rising LBO financing costs, risky PIK deals, underwater existing holdings...should we go on?
With news this week that PE heavyweight CVC has decided to postpone their public listing, and existing deals from the sector being restructured, we decided to delve more deeply into the space.
Over the past year, a culmination of factors has meant that new private equity deals don’t look that attractive and existing deals are much harder to now exit.
After gaining a huge amount of traction post 2009, we think that the golden era for the sector could be finally coming to a close.
Rising interest rates
It’s no surprise that one of the key elements at play here is the rise in global interest rates over the past 18 months.
Let’s take a basic example of a PE firm looking to do a leveraged buy-out (LBO) of a target company. This is traditionally financed by debt, which comes with an interest charge in line with current market rates.
When you consider the move higher in the base rate, plus the market uncertainty in general, the spread above the base rate being applied for LBO’s has dramatically increased.
In one recent FT piece we read, Carlyle struggled to get one deal over the line because the debt financing rate of circa 12% was basically the same as the return it hoped to make on the target.
For many deals in the LBO world that have already been struck, another problem surfaces. To ease pressure on refinancing companies that might struggle to carry the existing heavy LBO debt, PE firms are turning to ‘payment-in-kind’ (PIK) loans.
In short, this involves paying interest on the original debt by taking on more debt. This saves the existing cash and helps liquidity right now, but piles on more risk further down the line.
The hope is that the company performs very well and the debt can easily be paid off, or that rates fall in the future and PIK debt can be refinanced lower.
Yet PIK loans are currently attracting interest rates around 16%, which can balloon repayment if it’s not done fast:
Buying at the top of the market
Back during the early stages of the pandemic when cheap financing was still around, PE had another boom period. This is shown by the amount of deal flow below:
Unfortunately, it now appears that this coincided with the top of the market. This is particularly true of PE firms that are included in venture capital, which involves taking equity in return for funding younger stage businesses.
The reasons for why this was the top of the market is the topic for another deep-dive entirely. However, we flag up why this is now a problems for PE firms.
They can’t exit and release liquidity from these existing holdings because there simply isn’t value in doing so. If they did, there would likely be no return versus the purchase price for the partners.
Yet at the same time, such capital needs to be released at some point otherwise some rather angry conversations will be had with third party investors.
For the rest of this article, we’ll discuss:
Why the large amount of dry powder could help
Why now could be the best time to strike new deals
How retail investors can get involved
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