Innovations are rarely just about superior performance. They are also about experimentation. And all new experiments breed their fair share of miscarriages.
Given the extraordinary impact that financial leverage has on equity returns, PE fund managers have spent the past 40 years sharpening their use of debt funding. It is the area where the industry has witnessed the most innovation, because leverage is the principal means through which PE fund managers maximize returns3.
Since the 2008 financial crisis, institutional lenders and PE firms have greatly benefited from increased regulation of the banking industry. In the past 15 years, they have grown their share of the corporate debt 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 structure4. That allows them to do two things. They can use their private debt divisions’ ability to underwrite loans as a bargaining tool when negotiating terms with third-party lenders, and they can acquire companies on the cheap by buying distressed debt at a discount, with the option of taking full control of the leveraged business if the latter defaults on its debt. Lender-led buyouts have become common.
With so much spare capital in the financial system, borrowers are frequently granted exceedingly generous terms, including the ability to draw interest-only loans (meaning that the principal is only repayable upon the sale of the business or when the loans reach maturity) or without the need to meet strict financial ratios (debt covenants).
Today, most buyouts with an enterprise value above $100 million are financed with covenant-lite bullet loans, meaning that the debt raised is not amortized but only repayable in full upon maturity or change of control, giving the borrower years to operate without constraint from its lenders.
The golden rule is to keep debt as a proportion of total funding at a manageable level. Up to 60% seems to work for most sectors, unless they are subject to sudden regulatory changes, technological disruption, or fierce cyclical downturns, in which case leverage ratios should be set much lower5.
The risk of default on debt obligations for many LBOs can be unusually high. Lengthy renegotiations with lenders, to amend covenants and extend maturities or, increasingly, via liability management exercises6, are just the start. Default can also lead to bankruptcy.
That makes the adoption of best practice principles imperative. Since few deal targets ever meet all the criteria to qualify as perfect LBO candidates7, practitioners must embrace investment and management discipline that can weather the test of time.
Parts of this post were adapted from The Good, the Bad and the Ugly of Private Equity by Sebastien Canderle.
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