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The private equity industry -- excluding VC, which represents a small fraction of total capital raised -- relies extensively on debt (LBOs, debt-financed infras

by cs702 4y ago

The private equity industry -- excluding VC, which represents a small fraction of total capital raised -- relies extensively on debt (LBOs, debt-financed infrastructure deals, debt-financed real estate deals, etc.), i.e., borrowing to juice returns. It's not a coincidence that the industry was born in the 1980's, when interest rates in the US began declining, after the Fed had increased them to combat high inflation in the 1970's. Ever since, for four decades now, interest rates have only declined and declined, in fits and starts, making life easier and easier for borrowers of all kinds: https://fred.stlouisfed.org/graph/?g=RveY https://fred.stlouisfed.org/graph/?g=RveY Many private equity deals that arguably were economically viable when the 10-year treasury's annual yield was ~0.6%, less than a year ago, may not be viable now that the 10-year treasury's annual yield is ~3%, and are likely to suffer financial distress if interest rates rise further -- say, 10-year treasury yields of ~5%, ~6%, or more. If that sounds high, keep in mind that the last time the Fed had to deal with high inflation, in the 1970's, the 10-year treasury yield rose to a peak of ~16%! Over the same past four decades, valuation multiples have only risen and risen, in fits and starts, making life easier and easier for those who make money by buying businesses, holding them for a while, and selling them down the road. For example, here's the ratio of US stock market capitalization to the size of the US economy (GDP): https://fred.stlouisfed.org/series/DDDM01USA156NWDB https://fred.stlouisfed.org/series/DDDM01USA156NWDB The rise in valuation multiples over the past four decades makes sense, given that the net present value of any business is inversely proportional to the discount rate used to value its future profits, and discount rates are equal to prevailing long-term treasury rates plus a premium. If interest rates continue to rise, valuation multiples are bound to decline too. -- EDITS: Changed language in response to comments below so it better reflects what I meant to write in the first place.

snake_doc 4y ago
> The private equity industry -- excluding VC, which represents a tiny share of total capital raised -- relies extensively on leveraged buyouts (LBOs), i.e., borrowing to juice returns. In 2021, buyout was ~30% PE funds raised, VC was ~10%, growth was ~10%. “Tiny” is not true anymore. https://www.bain.com/insights/private-equity-market-in-2021-global-private-equity-report-2022/ https://www.bain.com/insights/private-equity-market-in-2021-...
- cs702 4y ago
  Thanks. Yes. I changed "tiny share" to "small fraction," and noted that the industry is much more than LBOs. Note that many other kinds of PE deals -- e.g., infrastructure, real estate, distressed secondary investments -- are done with lots of leverage too.
balderdash 4y ago
Most LBOs aren’t really that interest rate sensitive, let’s say you buy a company for $100m dollars 12x EBITDA, and 15x unlevered free cash flow ($7m), you would have put $50m of non amort. debt in the business @ 3%, so had a $1.5m interest payment. Lets say that doubles to $3m, earnings would have to be cut in half to not be able to service debt…
- abirch 4y ago
  Correct. Many of the large private equity companies were started in the 1980's when the rates were significantly higher than they are today.
- cs702 4y ago
  [EDIT: the data in this paragraph is WRONG! See comment below.] 12x EBITDA? Unlikely. According to the article, the average valuation multiple for US deals to take firms private is 19.3x EBITDA. A 3% rate for a leveraged entity? Unlikely. Current high-yield spreads are in the neighborhood of 500-600bp, on top of treasury rates. So, you'd need 60% more debt (19.3/12) to keep the same capital structure [EDIT: this last sentence is WRONG! The amount of debt needed would be the same, because the correct EV/EBITDA multiple is 12.3x. See comment below.], and the debt would be 2-3x more expensive, leaving much less margin for a downside scenario, say, in the event of a prolonged recession, rising rates, and/or declining valuation multiples. If all three of those things happen at the same time, things could get... ugly.
  - mbesto 4y ago
    > According to the article, the average valuation multiple for US deals to take firms private is 19.3x EBITDA. That's on a PIPE, which is a small subsection of all PE buyouts. Average multiples for ALL buyouts is 12.3x in NA: Average buyout multiples in 2021 rose 9% to 12.3x in North America, and, despite a slight decline, still stood at a lofty 11.9x in Europe (see Figure 14). https://www.bain.com/globalassets/noindex/2022/bain_report_global-private-equity-report-2022.pdf https://www.bain.com/globalassets/noindex/2022/bain_report_g...
    - 4y ago
spamizbad 4y ago
I don't think LBOs are that sensitive to interest rates are they? There was a ton of them in the 1980s when rates were still in the double digits.
- deleted 4y ago
  [deleted]
- swader999 4y ago
  Interest rate trends are more of a factor.
blabberwocky 4y ago
LBOs haven’t been the defining structure of PE for a while now, though leverage is still a key ingredient. The massive growth of the “PE industry” over the last decade has really been on the credit side (which does include equity plays, e.g., in real assets and distressed debt that leads to equity positions) despite the low interest rate environment.
- cs702 4y ago
  Thanks! Yes. I updated my comment.
- paganel 4y ago
  Do you happen to know if “private credit” (I don’t know if that is the actual correct term) is a big part of PE’s investments? I stumbled upon mentions of it more and more during the last 2 years (I’d say) and it kind of gave me some “this can’t be structurally right”-vibes. Or maybe that is just a very small market, comparatively speaking, and I’m talking bs, hence my question.
  - blabberwocky 4y ago
    Yes, it’s now a major business for the big PE firms (which today are really diversified investment managers) with AUMs that can significantly exceed that of (traditional) corporate PE. But its their credit vehicles that invest in credit. So their corporate PE funds might do buyouts or growth equity or whatever, but won’t generally be direct-lending or buying securitized debt.
  - mbesto 4y ago
    It's absolutely part of the investment structure. It's no different from buying a house that you would rent out for yield. If your yield outpaces the costs (maintenance, taxes, utilities, AND the mortgage rate) then you are basically have an arbitrage. This is no different from what PE does and is why they typically leverage ~50% of the acquisition price.
    - clairity 4y ago
jollybean 4y ago
So your summary point applies irrespective of whether companies are leveraged with debt or not. Cost of Capital is rising across the board.
- ezekiel11 4y ago
  what does this mean if your company is acquired and run by a private equity? will the rising fed rate mean that they are looking to cut out the highest salaries? am I better off not takin a higher salary because that might paint a red target on myself?
  - deleted 4y ago
    [deleted]
  - jollybean 4y ago
    It just means that when entity A wants to buy entity B, they have a general 'cost of capital they use to determine whether or not they want to buy something - and it doesn't matter if it's with cash or debt really. If you're an employee worrying about stuff, well, I wouldn't unless you're the CEO and have the power to make huge investments ... If you are a very profitable company, i.e. 'cash cow' without a lot of debt, then private equity may be interested in buying your company with heavy borrowing, using the profits to pay for the debt. Another way to look at it is, the company is not taking enough risk given the price of cash available in the market. One thing a company might want to do is take on debt and extend the business. If it's a private company with strong board control, and the shareholders don't want to sell, well, then you don't have to worry. As for companies that do get acquired, this notion that PE just wants to screw things up short term etc. is a bit bullshit. Burger King was acquired by that famous Brazilian outfit, and they turned the company around. In that case, probably some execs got fired to clear the path for the new vision, but it will vary case by case. The company might get split up into components. Maybe there is a garbage part of the company dragging on revenues. Maybe that supposedly crappy part of the company is actually more 'long term' and killing R&D would hurt the company, but that's surprisingly hard to establish. A lot of R&D is a waste. With rising interest rates, debt becomes more expensive, and companies have less to worry about getting bought out like this - of course, companies that are carrying debt have a greater burden. In summary, companies probably need to adjust a bit given interest rates. This is where a good CFO comes in.
M3L0NM4N 4y ago
Sorry but ain't no way 10 year is going to 5-6%... I'd wager it's very likely peaked at 3.5% and it won't break that again (for this cycle). Valuation multiples are (relatively) crushed, and I don't think we'll see much more of a multiple compression. What we will see, in both private and public markets, is when businesses adjust their earnings forecasts for the (very likely) impending recession. If you look at Wall Street numbers companies are still forecasting growth pretty every quarter through 2023. Now, that doesn't seem very likely to me. The deal is, the public markets will overreact as always and sell off harder, but private equity will stay more fairly valued because of it's inherent lack of liquidity (two wrongs make a right).
- RC_ITR 4y ago
  >Sorry but ain't no way 10 year is going to 5-6% People like to say this because of how negative the consequences would be, but that is not a reason why it won't happen. FWIW, given that it would only affect the US Gov't's new issuances, it's not impossible for them to let it happen.
  - M3L0NM4N 4y ago
    I think this administration and the current Fed chair are very averse to the negative consequences, that's why I'm saying it.
    - RC_ITR 4y ago
      I would love to have heard your thoughts as of 1Q21 on 3.5% using the same inputs. There were brand-name crossover (I won't call them HFs) folks claiming that we would never see positive inflation ever again (right before that fateful Apr-21 print)
      - M3L0NM4N 4y ago
        You're right, in 1Q21 I probably wouldn't have even guessed 3.5% But what do you mean by positive inflation though? Like CPI > 0% YoY? Cause that's the craziest thing I've ever heard.
qwertyuiop_ 4y ago
Very insightful. Do you work in finance ?
pirate787 4y ago
Regulatory and tax changes in the 1980s created private equity. Declining interest rates juiced it, as has computerization, but the fundamental change was Reagan's policy of financial deregulation and reducing capital gains and marginal rates so that entrepreneurs had more money to invest.
- missedthecue 4y ago
  What specific regulatory changes occurred in the 1980s that created PE? KKR, a pioneer of the industry, was started in the '70s and they did a landmark $380 million deal in 1979, which is billions in today's money. The first LBO was of Orkin Pest Control in 1964 and there were about a half dozen other LBOs in the 60's.

by cs702 4y ago

snake_doc 4y ago

> The private equity industry -- excluding VC, which represents a tiny share of total capital raised -- relies extensively on leveraged buyouts (LBOs), i.e., borrowing to juice returns. In 2021, buyout was ~30% PE funds raised, VC was ~10%, growth was ~10%. “Tiny” is not true anymore. https://www.bain.com/insights/private-equity-market-in-2021-global-private-equity-report-2022/ https://www.bain.com/insights/private-equity-market-in-2021-...

cs702 4y ago
Thanks. Yes. I changed "tiny share" to "small fraction," and noted that the industry is much more than LBOs. Note that many other kinds of PE deals -- e.g., infrastructure, real estate, distressed secondary investments -- are done with lots of leverage too.

balderdash 4y ago

Most LBOs aren’t really that interest rate sensitive, let’s say you buy a company for $100m dollars 12x EBITDA, and 15x unlevered free cash flow ($7m), you would have put $50m of non amort. debt in the business @ 3%, so had a $1.5m interest payment. Lets say that doubles to $3m, earnings would have to be cut in half to not be able to service debt…

abirch 4y ago
Correct. Many of the large private equity companies were started in the 1980's when the rates were significantly higher than they are today.
cs702 4y ago
[EDIT: the data in this paragraph is WRONG! See comment below.] 12x EBITDA? Unlikely. According to the article, the average valuation multiple for US deals to take firms private is 19.3x EBITDA. A 3% rate for a leveraged entity? Unlikely. Current high-yield spreads are in the neighborhood of 500-600bp, on top of treasury rates. So, you'd need 60% more debt (19.3/12) to keep the same capital structure [EDIT: this last sentence is WRONG! The amount of debt needed would be the same, because the correct EV/EBITDA multiple is 12.3x. See comment below.], and the debt would be 2-3x more expensive, leaving much less margin for a downside scenario, say, in the event of a prolonged recession, rising rates, and/or declining valuation multiples. If all three of those things happen at the same time, things could get... ugly.
- mbesto 4y ago
  > According to the article, the average valuation multiple for US deals to take firms private is 19.3x EBITDA. That's on a PIPE, which is a small subsection of all PE buyouts. Average multiples for ALL buyouts is 12.3x in NA: Average buyout multiples in 2021 rose 9% to 12.3x in North America, and, despite a slight decline, still stood at a lofty 11.9x in Europe (see Figure 14). https://www.bain.com/globalassets/noindex/2022/bain_report_global-private-equity-report-2022.pdf https://www.bain.com/globalassets/noindex/2022/bain_report_g...
  - 4y ago

spamizbad 4y ago

I don't think LBOs are that sensitive to interest rates are they? There was a ton of them in the 1980s when rates were still in the double digits.

deleted 4y ago
[deleted]
swader999 4y ago
Interest rate trends are more of a factor.

blabberwocky 4y ago

LBOs haven’t been the defining structure of PE for a while now, though leverage is still a key ingredient. The massive growth of the “PE industry” over the last decade has really been on the credit side (which does include equity plays, e.g., in real assets and distressed debt that leads to equity positions) despite the low interest rate environment.

cs702 4y ago
Thanks! Yes. I updated my comment.
paganel 4y ago
Do you happen to know if “private credit” (I don’t know if that is the actual correct term) is a big part of PE’s investments? I stumbled upon mentions of it more and more during the last 2 years (I’d say) and it kind of gave me some “this can’t be structurally right”-vibes. Or maybe that is just a very small market, comparatively speaking, and I’m talking bs, hence my question.
- blabberwocky 4y ago
  Yes, it’s now a major business for the big PE firms (which today are really diversified investment managers) with AUMs that can significantly exceed that of (traditional) corporate PE. But its their credit vehicles that invest in credit. So their corporate PE funds might do buyouts or growth equity or whatever, but won’t generally be direct-lending or buying securitized debt.
- mbesto 4y ago
  It's absolutely part of the investment structure. It's no different from buying a house that you would rent out for yield. If your yield outpaces the costs (maintenance, taxes, utilities, AND the mortgage rate) then you are basically have an arbitrage. This is no different from what PE does and is why they typically leverage ~50% of the acquisition price.
  - clairity 4y ago

jollybean 4y ago

So your summary point applies irrespective of whether companies are leveraged with debt or not. Cost of Capital is rising across the board.

ezekiel11 4y ago
what does this mean if your company is acquired and run by a private equity? will the rising fed rate mean that they are looking to cut out the highest salaries? am I better off not takin a higher salary because that might paint a red target on myself?
- deleted 4y ago
  [deleted]
- jollybean 4y ago
  It just means that when entity A wants to buy entity B, they have a general 'cost of capital they use to determine whether or not they want to buy something - and it doesn't matter if it's with cash or debt really. If you're an employee worrying about stuff, well, I wouldn't unless you're the CEO and have the power to make huge investments ... If you are a very profitable company, i.e. 'cash cow' without a lot of debt, then private equity may be interested in buying your company with heavy borrowing, using the profits to pay for the debt. Another way to look at it is, the company is not taking enough risk given the price of cash available in the market. One thing a company might want to do is take on debt and extend the business. If it's a private company with strong board control, and the shareholders don't want to sell, well, then you don't have to worry. As for companies that do get acquired, this notion that PE just wants to screw things up short term etc. is a bit bullshit. Burger King was acquired by that famous Brazilian outfit, and they turned the company around. In that case, probably some execs got fired to clear the path for the new vision, but it will vary case by case. The company might get split up into components. Maybe there is a garbage part of the company dragging on revenues. Maybe that supposedly crappy part of the company is actually more 'long term' and killing R&D would hurt the company, but that's surprisingly hard to establish. A lot of R&D is a waste. With rising interest rates, debt becomes more expensive, and companies have less to worry about getting bought out like this - of course, companies that are carrying debt have a greater burden. In summary, companies probably need to adjust a bit given interest rates. This is where a good CFO comes in.

M3L0NM4N 4y ago

Sorry but ain't no way 10 year is going to 5-6%... I'd wager it's very likely peaked at 3.5% and it won't break that again (for this cycle). Valuation multiples are (relatively) crushed, and I don't think we'll see much more of a multiple compression. What we will see, in both private and public markets, is when businesses adjust their earnings forecasts for the (very likely) impending recession. If you look at Wall Street numbers companies are still forecasting growth pretty every quarter through 2023. Now, that doesn't seem very likely to me. The deal is, the public markets will overreact as always and sell off harder, but private equity will stay more fairly valued because of it's inherent lack of liquidity (two wrongs make a right).

RC_ITR 4y ago
>Sorry but ain't no way 10 year is going to 5-6% People like to say this because of how negative the consequences would be, but that is not a reason why it won't happen. FWIW, given that it would only affect the US Gov't's new issuances, it's not impossible for them to let it happen.
- M3L0NM4N 4y ago
  I think this administration and the current Fed chair are very averse to the negative consequences, that's why I'm saying it.
  - RC_ITR 4y ago
    I would love to have heard your thoughts as of 1Q21 on 3.5% using the same inputs. There were brand-name crossover (I won't call them HFs) folks claiming that we would never see positive inflation ever again (right before that fateful Apr-21 print)
    - M3L0NM4N 4y ago
      You're right, in 1Q21 I probably wouldn't have even guessed 3.5% But what do you mean by positive inflation though? Like CPI > 0% YoY? Cause that's the craziest thing I've ever heard.

qwertyuiop_ 4y ago

Very insightful. Do you work in finance ?

pirate787 4y ago

Regulatory and tax changes in the 1980s created private equity. Declining interest rates juiced it, as has computerization, but the fundamental change was Reagan's policy of financial deregulation and reducing capital gains and marginal rates so that entrepreneurs had more money to invest.

missedthecue 4y ago
What specific regulatory changes occurred in the 1980s that created PE? KKR, a pioneer of the industry, was started in the '70s and they did a landmark $380 million deal in 1979, which is billions in today's money. The first LBO was of Orkin Pest Control in 1964 and there were about a half dozen other LBOs in the 60's.