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Investment Warnings: Beware these record highs in private equity

We keep a folder of ‘red-flag market indicators’ – developments that make us very uneasy indeed – and one of them is the record-high debt levels with which some private equity investors appear a little too comfortable

11/07/2019

Andrew Williams

Andrew Williams

Investment Specialist, Equity Value

The Value Perspective’s folder of what we call ‘red-flag market indicators’ continues to strain at its seams as investors tread a precarious line between confidence and complacency.

Take, for example, Bain & Company’s 2019 Global Private Equity Report, which highlights the sector’s strengths – as well as a sobering number of what it chooses to characterise as not weaknesses but “challenges”.

Offering a neat bridge back to a previous one of our Investment Warnings – on so-called ‘covenant lite loans’, which as the names implies imposes fewer restrictions on a borrower – the report notes how these instruments have also become increasingly common in private equity markets “in the second half of this cycle”, while “debt multiples have entered territory not seen since the peak of the last cycle”.

In the years following the global financial crisis, the report continues, “regulators discouraged multiples of six times earnings before interest, taxes, depreciation and amortisation (EBITDA). Yet in the Trump era’s more relaxed regulatory environment, the share of deals with multiples of greater than seven times EBITDA has risen to almost 40% of the total” – as the following chart illustrates.

Share of overall US LBO market, by leverage level

bainreport1.JPG

Source: LPC, taken from the Bain Global Private Equity Report 2019

 

What is more, the Bain analysts suggest, “the true leverage deployed in many deals may also have been understated”. “As is often the case in times of high risk tolerance, banks have allowed borrowers to calculate multiples based on projected earnings instead of actual results,” they add.

Of course, such calculations tend to “bake in” expectations for cost-cutting, synergies and revenue increases that may not actually materialise.

According to the report, the “inevitable effect” of the heavy competition for assets and the flood of capital –  from both debt and equity – into the private equity market since 2014 has been an increase in asset prices to all-time highs.

As the following chart shows, the average multiple for leveraged buyouts in the US and Europe was around 11x EBITDA in 2017 and 2018, which is higher than the run-up to the financial crisis.

 

Average EBITDA purchase price multiple for US LBO transactions

bainreport2.JPG

Source: LPC, taken from the Bain Global Private Equity Report 2019

“These dynamics – abundant capital on easy terms, pressure to do deals, rising asset prices and an uncertain economic outlook – raise all the usual end-of-cycle red flags,” notes the report, before concluding that, as a result, some private equity firms are changing their investment approach.

Here on The Value Perspective, we certainly hope this is so since recent behaviour suggests risk is slipping ever further down investors’ list of priorities as the hunt for returns becomes all-consuming. And when that happens, it is time to tread carefully.

Author

Andrew Williams

Andrew Williams

Investment Specialist, Equity Value

I joined Schroders in 2010 as part of the Investment Communications team focusing on UK equities. In 2014 I moved across to the Value Investment team. Prior to joining Schroders I was an analyst at an independent capital markets research firm. 

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