To many, private M&A seems healthy and offers little cause for concern. A surface review reveals a record number of transactions and easy liquidity. A deeper look uncovers cause for concern, however; aggressive underwriting and elevated leverage held by nontraditional lenders underpin many transactions, which may portend future challenges.
This article focuses upon one such challenge—when non-deal related, external issues of owners impact the target companies or assets they own. An example of these external issues occurred in the financial crisis, when many hedge funds that held illiquid debt, real estate, and thinly traded “public equity” experienced unprecedented levels of redemptions. As a result, multiple hedge funds were unable to support their investments that required additional capital. Ultimately, the funds faced the Hobson’s choice of holding assets gasping for liquidity or fire-selling into a depressed market.
It appears that a similar dynamic may be developing, but with different players. As Mark Twain is reported to have said, “History doesn’t repeat itself, but it often rhymes.”
As the current economic expansion stretches into its 11th year, the global private equity industry continues to raise and invest a record quantum of capital. Preqin reports that $426 billion was raised globally in 2018 by private equity funds, almost double the amount raised in 2012. In turn, these funds participated in $582 billion worth of buyout deals globally in 2018, the highest level seen since 2007, according to DealLogic.
The enabler of this activity has been the private credit market. Private credit funds hold $770 billion in assets under management, almost triple the amount from 2009. According to Preqin, private debt funds have
$269 billion in dry powder, up from $100 billion in 2009. Unsurprisingly, the fierce competition among private credit lenders to deploy their capital continues to erode underwriting standards. This is evidenced by the record high volume of covenant-lite loans—85% all leveraged loans in 2018, compared to less than 10% in 2010, as tracked by LCD.
Furthermore, a combination of high leverage relative to historical standards and low rates permit private equity funds to pay ever more for assets while predicting they will achieve their hurdle rates.
Pitchbook reports that the average EBITDA purchase price multiple for U.S. leveraged buyout (LBO) transactions was 11.5x in the four quarters that ended March 31, 2019, with average leverage of 5.8x and almost 40% of deals employing leverage exceeding 7.0x. This compares to leverage of less than 4.0x in 2009 and a peak of 6.0x in 2007. Current transaction multiples may be even higher than reported, as about one-quarter of LBOs were financed based on “adjusted” EBITDA numbers, according to the International Monetary Fund.
Given elevated acquisition multiples, competition, leverage, and covenant-lite loans, many observers expect both private equity and private debt to underperform during the next cycle.
For lenders and turnaround practitioners, stressed or distressed deals involving private equity, private debt, or both present unique challenges that require bespoke solutions. In the author’s experience, the most complex challenges involve problems stemming from underlying ownership distress.
Most restructuring professionals are quite familiar with financial and operating distress. Fewer specialize in ownership distress—challenges that encumber or impair the value or liquidity of underlying businesses or assets because sponsors are unable to invest additional capital when required. Most commonly, ownership distress that results in challenges for underlying investments stem from end-of-life funds, fragmented ownership, and misalignment.
End-of-Life Funds. Restructurings involving end-of-life funds, often referred to as “zombie funds,” can be complex and challenging. Typically, end-of-life funds have limited capital to invest and a short timeline for realization. Fund lives often compound these problems. Paradoxically, general partners (GPs) who cannot invest necessary additional capital to save a business have little incentive to monetize remaining assets, as doing so forces the reality of facing the real end of their fund. Solving these issues for GPs and limited partners (LPs) requires comprehensive restructuring to address ownership challenges.
For example, consider a company that is pursuing a stressed refinancing and is owned by an end-of-life fund. If there is a funding shortfall coupled with an equity sponsor past its investment period, the investment suffers because the sponsor cannot support the refinancing by infusing necessary capital. These same sponsors frequently refuse to sell into a “depressed market” and instead hold these assets at optimistic valuations. For similar reasons, investment managers avoid recapitalization in lieu of sale, reasoning that outside capital would be excessively dilutive.
Instead of asset sales or forced liquidations, fund-level debt presents an alternative to asset sales or recapitalizations. Borrowing costs may also be reduced with an asset-level financing backed by a “fund guarantee” from other assets within the same fund. These forms of financing are often available when other forms of credit are scarce. Further, in more challenging situations, even fund-level debt that carries equity participation and is perceived to be “expensive” may be better for the sponsor than a forced sale, recapitalization, or liquidation.
Fragmented Ownership. Companies or assets with fragmented ownership structures can easily fall victim to a stalemate among owners. In a recessionary environment, fragmented ownership groups often struggle to reach consensus on strategy. Differing investment holding periods, strategies, and liquidity present unavoidable points of disagreement. Examples of fragmented ownership often involve club deals with multiple family offices; independent sponsors, which often have multiple funding sources; and other traditionally passive investors. They may also include minority interest equity owners, such as mezzanine funds; post-reorg equity held by multiple hedge funds; and noncontrolling private equity firms.
Long-held assets with fragmented ownership structures typically suffer from governance challenges, transfer restrictions, tax complications, or legal issues. To help fragmented owners of good assets trapped in complex ownership disputes plan a path forward, someone, often an outside party, must build consensus amongst the ownership group. Such solutions demand political and investing skill. The combined skill set of a Henry Clay and Warren Buffett is rare; yet both abilities are necessary to develop and implement a restructuring plan in such circumstances.
Tender offers may be one solution to the fragmented ownership issue. They allow businesses with multiple minority owners to offer optionality to those who wish to exit at a fair price while allowing others to remain. However, it can be challenging to find an investor who is comfortable aggregating noncontrolling interests.
Misalignment. Effective asset management requires vigilance. Experience indicates that general partner asset management vigilance wanes when financial incentives diminish. With one bump in the road, the sponsor of a deal can become economically motivated to focus on its next transaction rather than enhancing the value of the last one.
Similarly, businesses may suffer when management teams have incentives that are out of the money. Prospectively, general partner and management disengagement may occur more frequently should the economy contract. Given the elevated leverage and purchase multiples being applied by private equity, economic incentives may disappear rapidly should markets erase the perception of future value appreciation.
Outside of traditional private equity sponsors, directly owned private assets (e.g., family offices, endowments, etc.) may be undermanaged or no longer strategic. Although the reasons for the absence of vigilance may not be the same among these owners, the impact does not differ. Absentee or inattentive ownership will erode value. Accordingly, these less traditional sponsors may seek assistance as well.
To solve the misalignment problem that leads to inattentive ownership, it is critical to make tough decisions early. As an example, fund recapitalizations that reset the value of the underlying assets and corresponding compensation structure for asset managers may preserve value. Working with and reincentivizing an asset manager or management team can be the key to expediently maximizing value for all constituents.
The scope of ownership distress is massive. According to Preqin, end-of-life private capital funds (older than 10 years) hold $525 billion in unrealized value as of December 2017. Nearly 75% of the unrealized value is held among private equity, venture, and growth funds.
Many of these situations have assets that require more time and additional capital to execute a turnaround, balance sheet restructuring, and exit plan, but are not financeable through traditional channels. In each of these situations, a flexible and creative capital source may be the key to unlocking value that may otherwise be impaired.
Each situation involving ownership distress is unique and requires a bespoke solution. Sponsors, lenders, and advisors are well-advised to explore all financing options to address the specific challenges presented by ownership distress. New capital is often required to improve the value of the underlying assets and reset stale valuations. Replacement capital is also likely required to cure the ownership distress before treating the other symptoms.
It may be possible to identify capital providers for each of these needs. Alternatively, there are funds that specialize in providing flexible, holistic capital to address ownership challenges and facilitate the improvement of underlying assets. This capital can take many forms, including debt, equity, or structured capital and may include:
For example, candidates for a comprehensive fund restructuring and/or fund financing can include 2006- to 2008-vintage private equity funds that are overlevered, need to consolidate competitors, and require new capital for growth.
Importantly, it is not uncommon to require multiple tools to address multiple issues. No two situations are alike, but all ownership distress requires creativity, flexibility, patience, and tenacity. It is best to engage in dialogue with experienced, flexible capital providers as early as possible to evaluate all options.