Innovation isn’t nearly superior performance. It’s also about experimentation. And all latest experiments lead to an inexpensive variety of miscarriages.
Given the extraordinary impact that financial leverage has on stock returns, PE fund managers have increased using leverage over the past 40 years. This is the world where the industry has seen essentially the most innovation, as leverage is the first means by which PE fund managers maximize returns3.
Since the 2008 financial crisis, institutional lenders and PE firms have benefited greatly from increasing regulation of the banking sector. Over the last 15 years they’ve increased their share of the company bond market.
Large-cap PE firms at the moment are amongst the most important corporate lenders: Apollo, Ares, Blackstone, Carlyle and KKR all play on each side of the capital structure4. This allows them to do two things. They can use their private debt division’s ability to underwrite loans as a bargaining tool when negotiating terms with third-party lenders, and so they can acquire businesses inexpensively by purchasing distressed debt at a reduction, with the choice to take full control of the leveraged business if it defaults on its debts. Lender-led takeovers at the moment are common.
Given the massive capital reserves within the economic system, borrowers are sometimes granted extremely generous conditions, including the potential for availing interest-free loans (i.e. the principal amount shouldn’t be repayable until the corporate is sold or the loans mature) or without having to stick to strict financial ratios (debt covenants).
Today, most acquisitions with an enterprise value of greater than $100 million are financed with bullet covenant-lite loans, meaning that the debt incurred shouldn’t be repaid but is simply repaid in full upon maturity or a change of control, allowing the borrower to operate for years without restrictions from its lenders.
The golden rule is to maintain the proportion of debt in total financing at a manageable level. Up to 60% seems to work for many sectors unless they’re subject to sudden regulatory changes, technological disruptions or sharp cyclical downturns. In this case, the debt ratios ought to be set significantly lower5.
For many LBOs, the danger of default on debt obligations may be unusually high. Lengthy renegotiations with lenders to vary covenants and extend terms or, increasingly, through liability management exercises6are only the start. Failure to pay also can result in bankruptcy.
Therefore, adopting best practice principles is imperative. Because few deal targets ever meet all the factors to qualify as perfect LBO candidates7practitioners must adopt an investment and management discipline that may withstand the test of time.
