Writer: Oskar Pulkkinen
Setting the scene
The past few months have seen markets in an uproar, with volatility and risk becoming inescapable realities. Investors are scrambling to profit off of perplexing market movements, dreaming of victories like Bill Ackman’s 2.6 billion CDS hedge. Meanwhile, private equity seemingly stands as a bulwark of the financial services industry, identifying and fostering promising firms that are gasping for air in this uncertain market environment. Now with a 1.5 trillion-dollar war chest, private equity is more ready than ever to dig out these diamonds in the rough. Nevertheless, the current market conditions can leave lasting battle scars which profoundly affect the long-term prospects of leveraged buyouts. Therefore, private equity must be mindful of the threats it faces in the long-run, while also bearing in mind the consequences of its more predatory practices.
The Uncertain Road to Recovery
While the global predictions for 2020 appear alarming, private equity should be more worried about the difficult road to recovery ahead. Expansionary policy will be difficult to implement due to policy tools which in many cases are already running at full steam, making it difficult to quickly respond to the high amounts of unemployment without at least some form of structural adjustment. Moreover, the psychological impacts of the crisis will have far-reaching consequences in terms of spending, which may not necessarily be resolved even if policy tools could be implemented to their full extent.
Nevertheless, the immediate effects of the coronavirus have led to discounted multiples and low EBITDA figures for companies, which are two factors private equity firms endeavour to improve to achieve successful exits. However, a long recovery could make it difficult to truly make winners out of these firms, which will potentially suffer from exogenous, macroeconomic slowdown for years to come. Yes, some companies may arise successful from these difficult conditions, but the 5 to 7 year period for which portfolio companies are held leaves a lot of room for uncertainty, making LBOs riskier.
Difficulties Finding Financing
This long-term uncertainty may also affect the ability to raise initial financing, especially when it comes to high-yield or mezzanine debt. These forms of debt account for 20-30% of an LBOs capital structure and are subordinate to other forms of financing used, which creates inherent risk. Especially with mezzanine debt, which draws in investors through embedded options, a positive outlook is vital to counteract the risk present with these forms of junior debt.
Meanwhile, corporate bonds are fighting a battle of their own. With about 120bn dollars in corporate bonds being recently downgraded to junk levels, the volatility present in the market is pushing investors to seek out more stable investments. Thus, in addition to being a difficult sell due to uncertain long-term outlooks, the condition of the corporate bond market itself is complicating LBO financing.
Rising leverage and bloated balance sheets
With strong relationships to lenders, finding financing should not be a massive concern for major private equity houses. A much greater source of worry is the constantly worsening liquidity crisis caused by companies struggling to find cash for their working capital needs, or in other words their day to day expenses. Usually, revolving lines of credit typically provide liquidity by acting as a sort of credit card for businesses. However, the limits are being reached for these lines and company balance sheets are already heavily levered due to easy access to debt over the past few years. This makes adding even more leverage to a company through an LBO a potentially dangerous idea.
What’s more, the ability for future debt paydown can be heavily affected by dire market conditions. As firms recover from the crisis and begin to scale production back to normal levels, increases in capital expenditure and rising net working capital will lower free cash flow, which makes it difficult for the sponsor to repay debt and thus increase their equity.
The Ace Up Their Sleeve
Bearing in mind all of these concerns, it should nevertheless come as no surprise that actors in the industry are already well aware of these threats to both their short term as well as long term prospects, and thus have ways to generate profit even among all this risk. As LBOs grant sponsors effective leadership of a company, there are multiple restructuring measures that may and often will be undertaken in dire circumstances to wring out revenue from acquisitions, and thus remove any doubt about the profitability of a buyout. Decreasing labour expenses, closing down redundant operations and other cost-cutting measures all form part of the oft critiqued “predatory” nature of private equity funds.
There is an argument for stating that by removing all the excess from a company, PE firms are promoting efficiency, and ensuring that a company is not wasting time and money on pursuing fruitless and unproductive ventures. In the case of exogenous shocks such as the coronavirus, however, firms are not failing because of inefficiency, but rather because of macroeconomic factors which are independent of a company’s business practices. This raises the question of whether the private equity business model is truly ethical under conditions in which the only profitable approach is to skin a company to the bone.
The state of the economy has left private equity firms in a zero-sum game. Poised to make considerable gains, the costs of their success will unfortunately be tangible and very real to the ordinary citizen. With an industry that seemingly can’t stop winning while the world around them is crumbling, perhaps it is time for private equity to not only be the bastion of the financial services industry, but of the economy as a whole, and take responsibility to ensure that its practices are constructive, as well as profitable.