Innovations are rarely about improved performance. They are also about experimentation. And all new experiments produce their fair share of abortions.
Given the extraordinary impact of financial leverage on equity returns, PE fund managers have intensified their use of debt funding over the past 40 years. This is the area where the industry has seen the most innovation, as leverage is the key means through which PE fund managers maximize returns.3.
Since the 2008 financial crisis, institutional lenders and PE firms have greatly benefited from increased regulation of the banking industry. Over the last 15 years, they have increased their share in the corporate loan market.
Large-cap PE firms are now among the largest corporate lenders: Apollo, Ares, Blackstone, Carlyle and KKR all play on both sides of the capital structure.4. This allows them to do two things. They can use their private loan divisions’ ability to underwrite loans as a bargaining tool when negotiating terms with third-party lenders, and they can acquire companies cheaply by buying distressed debt at a discount, with the option to take full control of the leveraged business if the latter defaults on its loan. Lender-led purchases have become common.
With so much excess capital in the financial system, borrowers are often given extremely generous terms, including the ability to take out interest-only loans (meaning that the principal must be repaid only upon the sale of the business or when the loan reaches maturity) or without the need to meet strict financial ratios (loan covenants).
Today, most buyouts with enterprise values ​​in excess of $100 million are financed with covenant-lite bullet loans, meaning the loan raised is not amortized but only paid in full upon maturity or change of control, giving the borrower years to operate without hindrance from its lenders.
The golden rule is to keep the debt to total funding ratio at a manageable level. Up to 60% seems to work for most sectors, unless they are subject to sudden regulatory changes, technological disruption, or severe cyclical downturns, in which case the leverage ratio should be set much lower.5.
The risk of default on debt obligations may be unusually high for many LBOs. Through lengthy negotiations with lenders, amending contracts and extending maturities or, increasingly, liability management exercises.6This is just the beginning. Default can also lead to bankruptcy.
This makes it essential to adopt best practice principles. Since few deal targets ever meet all the criteria to qualify as perfect LBO candidates7Practitioners must adopt an investment and management discipline that can stand the test of time.
Parts of this post have been adapted from The good, the bad and the ugly of private equity By Sebastian Canderley.
