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Private Equity: When Options are Few, the Wise Adapt - Arshiya Hendi

In the current economic downturn, where uncertainty lurks and conventional strategies falter, private equity stands as a beacon of audacity and innovation. Often watched with a mix of intrigue and disdain, private equity firms have long been synonymous with mystery, wielding investment strategies that raise eyebrows. However, it is precisely in these periods of economic downturn, with limited options and a pressure to outperform, that private equity unleashes its greatest asset: creativity. Armed with unconventional methods and an unyielding spirit, these financial pioneers push the boundaries of innovation to reap rewards where others see only obstacles.


In this article, we delve into the captivating world of private equity, uncovering the ways in which it has adapted in the face of a surplus of time-contingent dry powder and a high interest rate environment, looking at methods such as higher equity stakes, minority stakes, a move to private credit, and the increased interest in club deals.


Traditional Private Equity


In 1982, a private equity (‘PE’) firm acquired Gibson Greetings Cards Inc. for $80m. Of this $80m price tag, $79m was financed through debt, while $1m came from a $660k equity investment shared by two partners and $340k from other committed investors. Sixteen months later, the company underwent an initial public offering (‘IPO’) at a $290m valuation. As a result, the two partners realised a return of 200x, turning their $330k equity investment into $65m each.


Subsequently, this buyout strategy, more commonly known as a Leveraged Buyout (‘LBO’), has become the preferred approach employed by PE firms to generate significant returns on their investments, where they typically target an internal rate of return (‘IRR’) of 20% to 25%. Of course, nowadays, such a high debt-to-equity ratio would not be accepted by lenders, as borrowers are expected to carry a greater share in the investment risk. Consequently, PE firms are required to contribute a considerably higher initial equity stake, akin to the manner in which down payments for mortgages have increased. The larger equity stakes required significantly impact a PE firm's ability to achieve their target IRR. Nevertheless, the recent years of low interest rates have created an environment in which PE firms can engage in LBOs with minimal additional costs, effectively allowing them to allocate an average of 20% to 30% in equity, financing the remainder through debt, often at ratios as high as 9x the debt-to-earnings before interest, taxes, depreciation, and amortization (debt/EBITDA).


However, the era of free money has come to an end. The days of exceptionally low interest rates – as low as 0.1% during the pandemic period – which allowed sponsors to borrow practically at zero cost, are now behind us. With the Bank of England rapidly hiking its base rate, currently at a record high of 4.5% (as of 15 May 2023), surpassing levels not seen since the 2008 Global Financial Crisis, PE firms are now unable to rely on their traditional LBO model to maximise returns. The rise in interest rates places a heavier burden on interest payments, reducing the levered free cash flows that PE firms use to deleverage their acquisition over their holding period of 7 to 12 years, presenting a significant obstacle for them.


Yet, despite the increased costs associated with borrowing, fundraising remains at high levels, with 2022 being the second highest year on record (see graph below). However, as projected, fundraising has experienced a significant decline in 2023.



The increasing supply of dry powder, which is considered as cash or very low risk, highly liquid marketable securities committed by limited partners (‘LP’), that has yet to be allocated by general partners (‘GP’), is estimated at $3.7tn, and has grown at a compounded annual growth rate (‘CAGR’) of 39% since 2005. This poses a complex but welcome challenge for PE firms, whose methods of deployment are becoming increasingly limited. The problem lies in the fact that these committed funds are time sensitive. When LPs commit their capital to a fund, a contractual agreement is established between them and the GP. Typically, the GP is granted a window of two to three years within which they must allocate the capital; otherwise they are obligated to return it to the LPs. Naturally, the last thing PE firms want to do is return capital. Therefore, they must adapt and employ innovative approaches to deployment, as they look to navigate the delicate tension between the time-sensitive surplus of dry powder and the high interest rate environment, which has forced PE firms to move away from traditional LBOs.


Higher Equity, Less Leverage


Among the adjustments made in response to the high interest rate environment, one of the more straightforward changes has involved adjusting the LBO acquisition model. In basic terms: putting up a higher equity stake and reducing reliance on leverage. The possibility to put down more upfront capital has been facilitated by this surplus of dry powder, which allows PE firms to be more flexible in financing their acquisitions. A notable example illustrating this change in strategy can be seen in Silver Lake Capital’s $12.5bn acquisition of Qualtrics. Silver Lake contributed $10bn in equity, and received a $1.5bn minority stake from Canadian Pension Plan Investments (‘CPP’), using only $1bn in debt. While this represents an extreme instance of the shift, there are also less radical illustrations of PE firms flaunting their equity muscles: Blackstone’s $4.6bn acquisition of Cvent, and Apollo’s $8.1bn acquisition of Univar, both of which had an equity component of around 50%.


The higher equity stake decreases the debt component, alleviating the burden of annual interest payments. This reduction in debt-related expenses is crucial for maintaining healthy free cash flow conversion rates, which are essential for PE firms aiming to deleverage their investments. Typically, PE firms target returns in three main ways: deleveraging, cost cutting, and multiple expansion. With the diminished potential for significant deleveraging, they must place their focus towards cost cutting and growing their businesses to drive multiple expansion, ultimately resulting in them driving returns. In fact, the present lack of leverage in the target’s capital structure paves the way for future inorganic growth strategies. For example, when borrowing conditions become more favourable, leverage can be used to execute strategic bolt-on acquisitions that lead to revenue and cost synergies, which targets the crucial multiple expansion.


Change in control? No Thank You!


It is interesting to note that deal volume has not dropped as harshly as deal value:

The resilience in deal flow within the PE sector can be attributed to the adoption of alternative acquisition strategies, most notably through minority stake acquisitions (i.e. an acquisition either equal to or less than 49% of a target). In these higher interest rate environments, where debt refinancing incurs exorbitant costs, sponsors look to focus on deals that are more plausible in the current tight market, and minority stake acquisitions fit the bill. The appeal of these deals lies in their ability to circumvent the triggering of change in control provisions, which require the new controlling buyer to refinance the existing debt in the company’s capital structure. When interest rates are high, such refinancing obligations can prove detrimental, as they impose additional costs on the acquisition price. Therefore, by acquiring the non-controlling interest, the capital structure becomes portable, enabling the buyer to acquire the company at the equity value rather than the enterprise value, which factors in the obligation of debt refinancing. An illustrative case is Cameco’s acquisition of a 49% stake in Westinghouse from Brookfield for $2.2b, which was half of the target’s equity value.


Moreover, minority investors have recently played a key role in offering alternative financing options to PE buyers. This was the role played by CPP in Silver Lake Capital’s aforementioned $12.5bn acquisition of Qualtrics. The $1.5bn commitment by CPP significantly alleviated the debt burden on Silver Lake Capital. Interestingly, sovereign wealth funds (‘SWF’) have taken the lead in private equity co-investment activity. A recent example of such involvement can be seen in Thoma Bravo’s $8b acquisition of business software provider Coupa Software, which involved a ‘significant minority investment’ from the Abu Dhabi Investment Authority. Moreover, Saudi Arabia’s SWF, Public Investment Fund, recently announced that it invests $2bn in capital a year in “venture, growth capital and small buyouts”, including KKR, Hellman & Friedman, and CVC, through its investment arm Sanabil.


On the topic of minority investments, PE firms have also extended their focus to bolstering their project finance capabilities by offering equity investments to strategic partners looking to undertake on capital-intensive projects. The energy transition has emerged as a critical area requiring private capital intervention, as evidenced by the $260b that has been raised in funds set up to target the energy transition and climate infrastructure. The need for capital has been further driven by the ongoing green subsidy war between the US and EU. In August 2022, the US unveiled the Inflation Reduction Act (‘IRA’), which offered up to $369bn in tax subsidies on renewable energy projects. In response, the EU retaliated by relaxing its historically strict rules surrounding state aid, allowing member states to implement their own subsidy schemes. Both of these moves have stimulated activity in the renewables industry, incentivising businesses to take advantage of these subsidies and drive innovation by embarking on new projects at a discount. These capital intensive projects not only present a ‘generational opportunity to put money to work’, but also allow PE firms to respond to the increased pressures to decarbonise their portfolios. As a result, between August 2022 and February 2023, $20.9b has been committed to combined renewables projects, along with approximately $5.5b in battery storage initiatives. One example of this commitment is Energy Capital Partners’ $300m equity investment in Braya Renewable Fuels, which facilitates the company’s aim of converting its refinery operations in Come By Chance, Newfoundland and Labrador, Canada, to accelerate its renewable fuels production.


Need a Loan? Better go Private!


Rapidly rising interest rates, surging from 0.1% in December 2021 to 4.5% by May 2023, have had a detrimental impact on syndicated bank loan financing. Big bank lenders found themselves unable to offload their loans from their balance sheets, resulting in hung debt and impeding their capacity to finance further transactions. For example, the $16.5bn underwriting of the LBO of Citrix resulted in lenders such as Goldman Sachs, Bank of America, and Credit Suisse losing $600mn in offloading half of the debt, with the other half still hung on their balance sheet. This restricted syndicated debt market has left the door open for private capital to usurp the role of bank loans in acquisition financing and fill the funding gap.




And PE firms have indeed stepped up to fill this gap, pushing their charge into the world of credit investing. Credit investing is regarded as less volatile and as coming with more predictable management fees than traditional LBO-based private equity. The growing prevalence of private credit in acquisition financing can be seen in Carlyle’s acquisition of Veritas Group’s stake in healthcare analytics company Cotiviti, where a consortium including Apollo, Ares and Blackstone wrote a $5.5bn credit loan to finance the acquisition. Moreover, the $4.5bn loan provided by Blackstone, Ares, Blue Owl and Oak Hill to finance Hellman & Friedman’s acquisition of Information Resource is yet another example of this increased reliance on private credit. Overall, private credit accounted for 80% of financing for middle-market buyouts in 2022. This share is expected to grow following the increased stress on US regional banks, marked by the collapse of First Republic Bank and Signature Bank. These events signal potential for the tightening of banking regulations, reminiscent of the aftermath of the 2008 financial crisis. This will act as yet another tailwind for PE firms, who look to move to this alternative method of deploying their surplus dry powder.


Many PE firms have, as a result, taken steps to bolster their private credit capabilities. For example, TPG has agreed a deal to buy debt and real estate manager Angelo Gordon for $2.7bn, which pushes the Texas-based PE firm into credit-based investments. Mubadala, the Abu Dhabi SWF, has acquired the Fortress Investment Group ($50bn AUM) from Softbank, which has transformed Mubadala into one of the largest credit investors in the world. Equally, Oak Street Capital has moved into LBO lending, as it seeks to raise $10bn to finance takeovers. The increased focus by sponsors on private credit, which offers more predictable returns, essential in the current climate, presents another method of deploying their capital. The trend can be seen in the following graph:




The success of private credit can also be attributed to its two key advantages for borrowers. Firstly, private credit facilitates a smoother and less complicated post-default workout process. With fewer lenders involved, restructuring a company's capital structure and navigating through a default scenario tend to be faster and more cost-effective for borrowers. Moreover, banks, driven by their obligations to depositors, have a lower risk appetite when it comes to loans, meaning that they are more rigid in their loan terms. Private credit, on the other hand, offers greater flexibility, which ultimately leads to higher recovery rates for private debt compared to syndicated loans. Secondly, private debt caters for closer relationships between lender and borrower. Considering fewer lenders are involved in these transactions, borrowers tend to have closer relationships, which allows for deals to be executed much quicker with more flexible terms than with a large syndicate of lenders.


Private Equity Forms a Club


Rather than facing the challenges alone, an increasing number of PE firms have decided to collaborate and undertake joint acquisitions, a practice commonly referred to as a club deal. The first quarter of 2022 saw PE consortiums account for $288bn of total deal value, representing a year-on-year increase of 17%. Prominent examples of these club deals include the consortium consisting of Blackstone, Carlyle Group, and Hellman & Friedman teaming up to acquire Medline Industries for $34bn, of which $14.8bn was in equity. Equally, Brookfield acquired Origin Energy for £10.1bn, teaming up with GIC and Temasek.


The increasing appeal of club deals stems primarily from their ability to provide sponsors with access to additional capital, lowering the debt burden on an acquisition and spreading its associated risk among multiple buyers. This strategy is very effective when access to debt may be limited, or in facilitating larger transactions that would be challenging for a PE firm to execute independently. Moreover, the presence of increased potential buyers, each armed with a large surplus of dry powder, intensifies competition, which drives up valuation multiples. The competitive environment becomes a significant factor in determining price. Therefore, the allure of club deals also lies in the reduction of competition for potential targets, which tend to become more scarce during economic downturns. By minimising competition yet still taking advantage of the surplus dry powder, club deals help mitigate the risk of buy-out multiples becoming excessively inflated. The benefits of this strategy is why 57% of GPs were likely to engage in a club deal in 2022, marking a notable increase from the 32% observed in 2021.


Conclusion


In this exploration of four interesting ways in which private equity firms have adapted their strategies to cater for this new high interest rate environment, we see them to have emerged as a force to be reckoned with, possessing the creative prowess to continue generating returns. Through successfully managing the tension between time-contingent dry powder and rising interest rates, these firms have proven their adaptability and their resourcefulness, demonstrating their ability to seize opportunities in high risk environments. Ultimately, in a challenging climate where options are few, private equity reminds us that the wise adapt, thriving in periods of uncertainty and pushing the boundaries of what is possible.

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