Private equity: Recaps suffer as leverage multiples rocket

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By:
Denise Bedell
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Tougher financing conditions are now making it harder to execute.

Leveraged recapitalizations have grown in popularity throughout the past year as private equity sponsors go to market with the companies they already own – taking advantage of cheap funding in order to take money out of their businesses. But, according to market players, this is getting more difficult as conditions in the LBO market are becoming more selective.

Rates for such deals are rising as credit quality drops and existing leverage increases. The market is there for higher-quality recapitalizations. However, for those private equity firms looking to squeeze money out of already highly leveraged assets it is becoming a tough sell.

Acceptable returns

In the first three quarters of the year, private equity firms doled out $13.5 billion in dividends to shareholders in Europe alone through the use of leveraged recapitalizations, according to research by Standard & Poor’s Leveraged Commentary Data. This is more than twice as much as private equity firms paid themselves through such deals in the whole of 2004 – dividends paid on recapitalizations totalled about $6 billion for the year. However, the number of private equity firms coming to market with leveraged recaps appears to be slowing as financing conditions worsen.

European private equity dividends
Source: Standard & Poor’s Leveraged Commentary Data
Rob Hedlund, head of high-yield capital markets at Lehman Brothers, says that the sorts of recaps where a private equity firm buys a business and then after four or five years raises some new debt to take some cash out are still reasonably well received. “Those kinds of deals are still reasonably acceptable to the market – it generally involves a good credit that has performed reasonably well. The market will evaluate the new leverage being put on it, but will not take a negative view just because it was a leveraged recapitalization,” says Hedlund.

But a breed of leveraged recap that has become increasingly popular this year, where sponsors come back to the debt market to refinance deals almost immediately after the initial financing has been executed, are now more problematic to pull off. “We have seen private equity firms buying companies and returning to the market within a matter of months, or even in some instances weeks, to recapitalize that company and take a dividend out to investors,” says Hedlund.

Half a turn

He says that these sorts of deals have become popular this year as sponsors have seen the acceptable leverage multiple to put on a deal go up rapidly. “After three or four months of holding a company, the private equity firms were seeing leverage available on that business increase by half a turn, and they were going back to the market to take that half a turn and take it out for investor profit.”

Hedlund says that there are fewer of these types of LBOs coming to market now as leverage multiples have topped out, so sponsors are not able to take debt out of the businesses they acquire so rapidly. Also, the cost of new leveraged debt has increased significantly, making new recaps more difficult, which Hedlund says is partly in response to the fact that leverage multiples are now as high as they have ever been. “A year ago a standard LBO was getting priced in the 8% to 9% range. These days it is more like 10% to 11% or even 11% to 12%.”

Credit quality

But he adds that this is also related to a deterioration in the quality of the sorts of credits being financed. “We are seeing lower credit quality and it is now rare to see subordinated tranches rated higher than triple-C,” he says.

Louise Purtle, analyst at fixed-income research firm CreditSights, wrote in a recent report that for various reasons LBO supply in general might have also peaked this year. “We do not expect LBO volumes to fall off a cliff anytime soon,” she wrote. “Such a view seems to fit better with a scenario of more extreme moves in the overall global interest rate and equity valuation regime than we are expecting. However, deal volume could well peak in 2005 and fall going forward.”