Private equity is struggling to spend cash as fast as it is raising it. Dealogic estimates that in the past three frenetic weeks, leveraged buy-outs with an enterprise value of $61bn have been announced. That includes the takeover of HCA, at $33bn the largest LBO ever. Unfortunately, money is coming in the door even quicker. Private Equity Intelligence thinks those buy-out funds currently on capital-raising roadshows aim to solicit $82bn.
The picture is more astonishing if one considers the backlog of uncalled capital available to buy-out funds, which stands at $297bn. This equates to the equity portion only of a takeover. Assuming 80 per cent of a typical deal is debt-financed, the total ammunition waiting to find a target is $1,485bn. Industry supporters argue that this represents, for example, just 12 per cent of the S&P 500’s market capitalisation. But the real question is not whether spending this much on takeovers of public companies is possible but whether it is wise.
Two factors suggest not. Cyclical risks have increased. Equity markets have risen, and thus the probability that targets are overvalued. Risk-free interest rates are higher, although average spreads on high-yield bonds, at 350 basis points, have not widened by too much. The main threat to financing may actually be from profits, which are at a cyclical high relative to output. Slower growth and cost inflation may dent margins. This, in turn, would threaten the service of the debt that private equity assumes to boost its stated, although not risk-adjusted, returns.
Second, some argue that a historic shift from public to private equity is occurring. Yet, if we are witnessing the birth of an asset class, it is one that now seems highly likely to underperform after adjusting for leverage. By necessity, buy-outs must now be less selective. Investors can either own public equity or invest in funds that must pay large takeover premiums to own public equity – and which charge meaty fees for the privilege. If less discriminating buy-outs are the future, it is probably best to be on their receiving end.