There were so many nuggets in Henry Kravis’ CVCA speech on Monday that you could blog about it for weeks. Today’s offering is an outline of Mr. Kravis’ argument that private equity-backed going privates are not using more debt to do so than in the past, despite the major drop in debt servicing costs as compared to the ten year period running from 1976-86.
When compared to the late 90s, for example, the data I’ve seen would suggest that the average U.S. firm is utilizing a bit more debt when a private equity firm undertakes a privatization process — with Total Debt/EBITDA multiples up about 0.5x.
But Mr. Kravis made a good case that we are no where near the leverage game that was being played by buyout firms such as KKR in the 1976-86 window. Here are some KKR case studies he used to make the point (all figures in US$):
$22 million purchase price
Source of funds: $20 million in debt (91%) and $2 million of equity (9%)
Source of funds: $307 million in “net” debt (86%), $23 million of preferred shares (7%) and $25 million of common equity (7%)
Source of funds: 81% debt, 2% preferred shares and 17% common equity
Source of funds: 81% debt, 14% preferred shares, 5% common equity
Source of funds: 96% debt, 1% preferred shares, 3% common equity
Source of funds: 65% debt and 35% common equity
Source of funds: 60% debt, 16% preferred shares, 24% common equity
These examples suggest that credit rating agencies are right to be sanguine about the state of the current senior debt market, although one recently warned that banks were holding larger pieces of individual corporate loans, decreasing the benefit that comes from a truly diversifed loan portfolio; concentration being a bad thing. Today, across the entire industry, the U.S. buyout market uses debt to fund an average of 70% of the total purchase price. Largely in keeping with KKR’s mid 90’s deal examples.
When compared with the current leverage component, if 30% of today’s deals are financed with equity, the sub 10% deals of the 1980s look awfully geared by comparison.
What the bigger equity cheques are doing, along with rabid competition among senior lender groups, is driving better terms: Mr. Kravis made the point by saying that as compared to the same company in 1999, a buyout deal today would look like this:
- the firm could borrow twice as much debt ($2.5B vs. $1.25B)
- pay an interest rate that was 75 basis points lower (Libor plus 225 bps vs. Libor plus 300)
- enjoy no financial covenants or tests (versus interest coverage test, fixed charge test, total debt / ebitda test, capex cap, etc.)
Mr. Kravis also thought that a 1980s era deal would be paying at least 400 bps more for its debt package than you’d find today. Interestingly, Mr. Kravis said that the aggressivenes of the senior debt market is “both good and bad”.
Although the lack of covenants gives the borrower more time to work out problems than before, “there are no warning lights now” of when you are getting into financial trouble. Mr. Kravis said that in the 1980s and 90s, when you had a problem with a portfolio company, you went to see your lead bank and you had “the conversation”. Today, with the use of CDOs and CLOs (think of conduits that firms package and sell their debt through to institutional investors), “you don’t know who your lenders are and there’s no one to deal with.”
In 1999 there were 62 U.S.-based leveraged loan providers, today they are 236. 80% of U.S. big ticket loans are now sold into these conduits by his estimate.
Mr. Kravis cautioned the audience about worrying about short term spikes in the debt market, claiming that long term bond rates have been stable for five years despite 17 increases in the overnight rate. That said, he advocated the use of fixed rates in all deals. On RJR, for example, there was a “reset” feature in a loan document that allowed the bank to charge a higher interest rate after a certain date if the credit markets had become more expensive. To keep RJR solvent when the reset date arrived, KKR had to invest another $1.7 billion in equity on top of the US$1.3 billion he had already put into the deal.
My theory about the larger equity-per-deal component you see today across the entire PE industry is simple: 1) it’s not that the lenders wouldn’t go for more leverage, it’s that the massive fund managers get a big chunk of their income from the 2% management fee; you can’t eat IRR. If putting up 30% in equity versus 10% means you need to raise a fund that’s 3x as large — but doesn’t require three times the number of investment professionals as the number of deals doesn’t change — you might as well be awash in management fees, as 80% of the deal profits go to the limited partners in any event (the math of preferred returns makes it a bit more complicated than that, of course); and 2) the best way to be in business 20 years from now is to do more conservative deals, and putting up more equity is the best way to de-risk a private equity deal and avoid a wipre-out down the road. If Fund manager X was shooting for 100% IRR deals using high leverage to get there and had a series of bankruptcies that changed the outcome of their fund, they’re done. No more fund. No more management fees. No more trips to the Ritz Hotel in Paris. LPs don’t need very high IRRs to stick with a fund for successive raises, and larger equity slices per deal reduces IRR as we all know.
While the “stars are aligned” in the private equity industry, Mr. Kravis acknowledged that “there will be something that will slow the growth rate” of the sector. “Trees don’t grow to the sky,” he teased, but he strongly suggested that there is a “misunderstanding on the part of the public and government” about what private equity funds are up to. This is largely due, he said, to the confusion people have between the mandate and behaviours of a hedge fund versus a private equity fund. While very much an issue in Europe, Mr. Kravis also sees confusion in the United States.
As for a collapse of a fund, Mr. Kravis put that to rest with the following example: if Blackstone (NYSE:BX) loses $1 - $2 billion on a failed deal, it will only impact a small part of their $88 billion under management. The carried interest will be affected by the netting effect, but the rest of the portfolio is made up of discrete businesses in different industries in diverse parts of the globe.
It may be hard to imagine that a $2 billion wipe-out wouldn’t affect a firm, but Mr. Kravis’ logic is unassailable.
Large private equity buyout firms have become the “Superstate” of the 21st century. And Kravis would make a good Caesar.