Private equity dealmakers are riding high on a wave of cheap debt, pushing buyout values to levels not seen since the financial crisis.
The deals may not yet be quite as large as those in the last buyout bubble that blew up spectacularly a decade ago, such as the $44bn buyout of energy company TXU that ended in one of the biggest bankruptcies on record.
But in one respect at least, 2007 is back: today’s deals are once again fuelled by supersized portions of cheap debt, with few strings attached.
Four leveraged buyouts worth $10bn or more have been announced since the beginning of January, a higher tally than in any year since 2007.
In about half of this year’s deals, private equity firms were able to raise debt financing amounting to at least six times the annual earnings before interest, tax, depreciation and amortisation (ebitda) of the company they bought.
Ebitda is a widely followed measure of profit that is calculated by taking a company’s headline earnings and adding back tax and interest payments, as well as non-cash charges such as depreciation and amortisation. It provides a rough indication of the money available for debt repayments.
This year’s latest big buyout is the $13.2bn takeover of the power solutions unit at Johnson Controls International by the private equity arm of Brookfield Asset Management, which plans to raise over $10bn of debt — close to six times its ebitda.
Leverage on this scale has not been used so aggressively since 2007, when a sudden dearth of buyers for corporate debts meant banks were forced to clog up their balance sheets with risky loans they had originally planned to sell on.
Now a plentiful supply of cheap credit is once again pushing asset prices higher, allowing private equity bidders to offer more money upfront for every dollar of profit they expect a company to earn.
This is starting to raise alarm bells. Janet Yellen, the former chair of the US Federal Reserve, told the Financial Times last month that she was worried by a “huge deterioration” in corporate lending standards, particularly for leveraged loans. The IMF has also singled out leveraged loans as a potential source of financial instability.
In the US at least, Obama-era regulations until recently prevented businesses from ratcheting up debt even further. But private equity groups have taken advantage of the Trump administration’s more relaxed approach by doubling the proportion of deals done with leverage of seven times or greater, which had often been barred under the old rules.
Bankers and deal lawyers warn that even these stark figures may understate the build-up of loose credit. That is because, as well as offering larger amounts of debt in proportion to a company’s profits, lenders have become less exacting about how those profits are defined.
Debt contracts now routinely include clauses allowing companies to inflate their ebitda numbers by “adjusting” current-year profits to include the expected fruits of future cost savings or growth plans. Yet the cash benefits of such initiatives may take years to materialise — if they arrive at all.
Also in fashion are “covenant-lite” loans, which deprive lenders of protections that customarily prevented borrowers from behaving recklessly, and allowed creditors to seize control when a company was in danger of missing payments.
Even at the height of the 2007 lending frenzy, only about one-fifth of financing deals were written with loose covenants. Now the figure is close to four-fifths. Credit rating agency Moody’s warned recently that this could hamper recovery rates for investors in the next downturn.
“In some cases it’s not really covenant-lite,” says an executive at one fund that specialises in writing such loans. “Some of the documents are so loose you might as well have no covenants at all.”
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