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Private equity: Pass the parcel

Private equity firms have a nice business flipping companies from one to another. But what happens when the music stops?

Along with party entertainers and goody bags, putting a treat in between every layer of newspaper in the pass-the-parcel game is symptomatic of the indulgent excess that is the modern-day children’s party. But it is a concept that the private equity industry has also embraced with enthusiasm: parcelling up companies and flipping them from one to another with a juicy payoff for all concerned each time the music stops. According to LCD, nearly half of all buyout activity in the past five years has been sponsor-to-sponsor deals – illustrating the extent to which this market has increasingly been feeding off itself.

Now that the music has been turned off and everyone has gone home, those left holding the parcel might not particularly like what they find when they look inside. Sponsors have been so used to flipping their investments within a very short time frame that they have probably not paid the attention to the business plans that they would have had they known they would be holding on to the company for longer. According to Fitch, the average time to recycling for a sponsor or trade buyout has fallen from 42 months in 2005 to 30 months today, and the terms of those refinancings are starkly more aggressive. When the financial projections of the most recent deals are compared with those of the prior trade (for the same asset), financial projections show average total leverage rising from 3.7x to 4.9x while cash interest cover falls from 4.3x to 2.9x. Bids have also factored in revenue growth averaging 9.5% (up from 7.9%) and margin expansion of 126 basis points in the first three years (up from 74bp). And this is for trades that could be separated by as little as 30 months.

When you are pretty sure that you will not be managing the business past year three, terms like this might not look too bad. But now that the market has turned, the refinancing bandwagon has well and truly rolled and sponsors are going to have to hang on to – and manage – their investments for far longer than they ever thought they would. And they are going to have to take a very close look at those projections and figure out just how they are going to meet them.

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