Tuesday 25 February 2020

Has Private Equity LBO'd the Hotel California?

According to this chart from Bain's 2020 LBO study, there seems to be about 2.5-3x as many LBO deal entries than exits in this cycle? 

For example in 2010-2012 there were around 3,000 deals per year, but in the last 4 years exits were only about 1,000-1,250. 

While the exit value of the sucessful deals seems to be about double what was invested, the question also arises of what happened to the other deals that haven't been exited after 5-10 years? 

Bain found that out of the successfully exited deals, 71% failed to meet the margin improvement targeted when the deal was entered into - and this has been during an economic recovery period and only covering exited deals. 

If after 5-10 years, only about 40% of deals are being exited and most of them were behind target, what has happened to the others? After all, this cycle has been the longest and most accommodating ever for US corporates. 

Meanwhile, in terms of the current market environment and outlook, we know that with record amounts of capital being raised from LP's, the last two years' US LBO's have been done at all time record valuations. 

According to S&P, 2018 and 2019 have seen average US LBO multiples of over 11x EBITDA (which means that half of all deals were done above 11x), with Europe only slightly behind. 

According to Bain, 10-year returns of US LBO's have been similar to the S&P index return, despite LBO companies being small to mid-cap in size and highly leveraged. 

This suggests there is no wholesale inefficiency in the LBO's and, in fact, the LBO sector is probably overcapitalized. 

The sources of return on exited deals also don't suggest any great value add by the GP's and instead highlight the dependency on margin levels and multiples.

Additionally, if only about 40% of the older deals are realized, it might raise questions on what valuations are being used on the remaining (struggling?) deals, to generate these stated IRR's.

We know the best vintages are done at 8-9x depressed EBITDA following a downturn, not at >11x on falling, late cycle EBITDA. 

To finance these record multiples, the GP's have arranged deals with ~5.5x EBITDA from senior loans (aka leveraged loans) and the balance, another ~5.5x, from equity. 

So these LBO financing structures and return outlooks are underpinned by a combination of corporate margins and valuation multiples. But unfortunately US margins are in the process of falling, as they always do late cycle, until there is a recession. 

Longer run average after tax profits as a percent of GDP are 5-7% vs 8.7% in Q3 2019. So circa 5% after a downturn and 7% after a growth cycle. If US profits fell to the middle of that range, 6% from 8.7% in Q3 19, profits would fall 41%. 

EDITDA is not as sensitive as after tax profits, but lets assume a 41% profit drop equates to roughly a 30% EBITDA drop for an average LBO company. 

Let's assume a recent LBO with $1 of EBITDA was done at $11 enterprise value, financed with a $5.50 senior loan and $5.50 of equity. Then after a downturn the loan market is only willing to finance LBOs at 8.5x EBITDA. 

Using the $1 of current EBITDA, this drops to 70c. At 8.5x the 70c EBITDA the company is worth just $5.95. But the senior debt was $5.50, so the equity residual has fallen to just 45c, vs the original LP commitment of $5.50; that's over a 90% loss of equity driven by a fall in margins and a fall in mulitples. 

So you would assume this would breach loan covenants and the deal would be toast?

But here is where it gets more interesting. LBO GP's are judged, in part, on how many deals go to zero. So if a company's business has not blown up and the issue is more the amount of debt/ EBITDA, then the GP's have an huge incentive to keep a bad deal alive. 

Over 5-10 years, as nominal GDP grows, most companies should see substantial revenue and therefore EBITDA growth, so by keeping a bad deal alive, even if it involves drip feeding more equity in after a downturn, it keeps management fees coming to the GP, a positive carry option for the GP on a recovery and avoids difficult conversations with LPs, but all at the cost of the fund IRR and liquidity to the LP.

Once an LP commits to a new private equity fund, during the investment period they pretty much can't get out of the capital calls and then they are dependent on when the GP chooses to exit investments, years later. 

So to abridge the famous song;

Welcome to the Hotel California
Such a lovely place (such a lovely place)...

...You can check out any time you like,
But you can never leave!'

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