According to the recently-released Bain & Company Private Equity Report 2020, private equity firms had over $2.5 trillion in dry powder at end of 2019.
Private equity players are actively looking for M&A deals and their demand for acquisition financing is pushing open debt markets. The fluctuations in the markets have created many willing buyers and willing sellers. Interest rates are still relatively low. This is the time for private equity to buy low and show value in identifying and analyzing investments.
$2.5 trillion in M&A cash will push debt for post-Covid world.
Big investments are already happening. The sovereign wealth fund of Saudi Arabia bought an 8.2% stake in Carnival Cruises after price dropped 90%. Many see this time as a buying opportunity and more deals will get done.
Generally, private equity firms don’t do all-cash acquisitions. According to Bain, 75% of buyout deals in 2019 had debt multiples of 6x EBITDA or higher. In the U.S., the average purchase price on a buyout was 11.5x EBITDA. So, the purchase price was roughly financed with 50% cash and 50% debt. As the $2.5 trillion in dry powder is invested in acquisitions, it’ll drive another $2.5 trillion in debt.
The tenure and pricing of debt will be more conservative
Lenders are looking at shorter-term loans since the long-term horizon is unclear. Also the long-term liquidity premiums will reduce borrower appetite. Tenures are likely to be three years or less. The market is not ready for five-year loans. Pricing has also become more conservative with 50 to 100 basis points dislocation above pricing of just four months ago.
Leverage will be lower
Historically, banks may have been comfortable with lending at 2.5x to 3.5x EBITDA but are now recommending 2x to 3x. Part of the reason is that EBITDAs are less predictable today and many companies will have large drop in profits. IMF projects that the global economy will contract by 3% in 2020; that means lower profits for most companies.
Banks are reluctant to lend after releasing $124 billion on lines of credit after crisis
The COVID-19 crisis hurt bank lending. The banks were the villains in the 2008 crisis as they shut off the cash spigot. This time, banks had a more positive initial response. CFOs rushed to assure liquidity and drew over $124 billion on their lines of credit in the first month of the crisis. Banks allowed borrowing on the lines to support their existing customers. However, with so much capital deployed already, banks are hesitant to lend any more. So bank lending stalled.
Governments lean in with stimulus; Banks can lean back
The CARES Act arranged for government-backed loans and the Fed stepped in to buy corporate bonds. With the government leaning in, banks read this as an opportunity to lean back. While some banks acted as conduits for the government-backed stimulus loans, lending unrelated to the stimulus programs dropped off.
Crisis drives banks to prune nonprofitable operations and retrench
Also the crisis was the impetus for all companies to prune less profitable relationships. Banks are closing low-profit businesses, getting out of unattractive markets, and shedding jobs where they can’t compete. For example, Bank of America, JP Morgan and Goldman Sachs are all ceding market share in Europe, where their margins were not as attractive. These are responsible actions for the lenders in this crisis, but it will create a tough market for borrowers.
Drop in credit ratings makes underwriting more difficult
Another discouraging trend is the drop in credit ratings. With uncertainty on timing and shape of recovery, credit rating agencies are considering downgrading ratings for a wide range of companies from ExxonMobil to Zara. Underwriters are skittish about lending with so much credit risk. One underwriter said he saw a lot of uncertainty in the syndication market for debt as “no one we can sell it to” today.
But “Debt will be back.”
A well-placed source with visibility into big players such as JP Morgan, Morgan Stanley, Deutsche Bank and smaller regional banks predicts: “The Saudi acquisition of Carnival clearly demonstrates that investors see value in even the most distressed assets. PE firms will also make opportunistic acquisitions and the successful marriage of M&A and acquisition leverage will return. The first dances may be more cautious and conservative, with lower leverage and higher costs. As the new normal comes into view leverage will creep up, costs will come down and volumes will rise. Active investors will have their long-awaited days in the sun. Bankers will resume making their fees. Debt will be back.”
