Private Equity Riding the Waves of Cheap Debt
2008 welcomed the largest recession since the Great Depression of 1929. In part, this resulted in heavy financial regulations during the Obama administration, where the lending of capital for acquisitions was highly limited to minimize risk and volatility. As is natural for the business cycle, economic recovery has been accompanied by the loosening of these limitations and has seen an increase in the usage of debt for purposes of buyout acquisitions. This has only intensified under the current Trump administration, which has been highly favoring free markets and business deregulation.
Private Equity firms have taken full advantage of regulatory cuts and cheap debt to make the biggest acquisitions and buyouts since 2007. Since January 2018 alone, four buyouts worth over $10 Billion have been announced, the largest of which was Blackstone’s acquisition of Refinitiv (Thomson Reuters financial and risk business), for $17 Billion. What stands out (negatively, for some) about these purchases have been the prices paid relative to the actual realised profits of these firms. This year alone, half of these acquisitions have had a value in excess of six times the earnings before interest, taxes, depreciation, and amortisation (EBITDA). EBITDA is the most widely used measure of profitability of a given company, and provides a rough approximation of the money available for debt repayments. Companies purchased at a value multiple factors bigger than their EBITDA frequently result in fears of a potential ‘bubble’. The negative ramifications are amplified by the debt used to make these acquisitions, as our modern financial system transports this risk across entire sectors and economies.
The industry that has seen a notable adoption of the aforementioned trend is the technology industry, where private equity firms are making more leverage-based buyouts than ever. Since November, 1,079 buyout deals were announced globally, worth over $71 Billion. With each passing year, the total value of these deals has increased with a peak of $177 Billion in 2015. Currently, private equity firms hold over half a trillion USD in assets under management, a figure that is double that of five years ago. A notable trend in these acquisitions has been that of ‘add-on’s’, which refers to a purchase of a new company by a private equity firm that increases the value of an existing company in the portfolio. These ‘add-on’ deals have made up 42% of recent buyouts, which, according to Christopher Elvin (Preqin’s Head of Private Equity), suggests “a growing prevalence of buy-and-build strategies as firms compete to provide scale and capture market share”.
Whilst these buyouts have created tremendous wealth for some, and generated an environment of consumer confidence, some key concerns have been raised. Jennet Yellen (former US Fed Chair) described the trend as a “huge deterioration” of corporate lending standards, and the International Monetary Fund pointed to leveraged loans as a potential source of financial instability. The practice does not appear to be slowing in the near future, particularly in regard to technology. As Christopher Elvin stated, “it seems unlikely that the flow of capital will slow in the near future, while the consistent year-on-year rise in the number of deals announced shows the sector has momentum. This may, in part, speak to the ubiquity of technology, which sees an ever-increasing number of potential investment opportunities available in the sector”.
A further key issue remains that the loans permitted have resulted out of very relaxed lending conditions. Not only have bankers permitted loans far in excess of EBITDA (profits), but the method with which these profits are measured has become increasingly more lenient. New debt-contracts allow companies to adjust their EBIDTA based on expected future cost saving schemes, which are far from realized currently in real cash terms.
Leveraging company value in acquisitions is in itself not a problem, given that the company will be able to generate this level of value at some point in the future. It is to be seen if this will be the case, and whether the private equity managers are able to generate the growth necessary to repay these debts. If not, the global economy will witness a tremendous amount of bankruptcies and a potential recession.