NEW YORK, Feb 15 (Reuters Breakingviews) - Debt necessity is proving to be the mother of private equity invention. With the cheap borrowing that fueled record-breaking years of leveraged buyouts gone, firms are digging deeper into their bags of tricks. Some methods involve unhealthier short-term thinking, but others are repeatable and sustainable, at least for a while – assuming frozen loan markets thaw before long.
THE PARTNER TRACK
High-yielding, B-rated debt typically provided for buyouts costs around 8.4% in interest, nearly twice as much as in January 2022. Private credit markets are also tightening: Lender Ares Capital (ARCC.O) committed 57% less capital last quarter than it did a year earlier.
With money scarce, firms can ask a takeover target’s existing investors to hang onto their stakes. Vista Equity Partners, for example, invited existing partial owners of KnowBe4 , including KKR (KKR.N), to stick around, saving as much as $800 million on the $4.6 billion cybersecurity-provider deal.
It’s not an easily repeatable tactic, however. There is no magic formula for finding suitably big companies with significant shareholders willing to stay.
THE DOUBLE-DIP
Vista itself also owned some of KnowBe4, thanks to an earlier investment. Sticking with an already-backed holding means a smaller incremental check and possibly at a cheaper price.
BDT Partners returned to Weber (WEBR.N) in December, agreeing to take the grill maker, of which it owns 48%, private again at a valuation 43% below the mid-2021 initial public offering price. Software developer SAP (SAPG.DE) is considering selling out of Qualtrics International (XM.O), the online survey company it took public in 2021, after its shares fell 75%. Private equity firm Silver Lake, which bought a stake alongside the IPO, said it might take control.
Businesses that went public by way of a special-purpose acquisition company could be a rich seam for such transactions. The de-SPAC Index is down 84% over the past two years.
THE CONTROL FREAK
With credit tight, “change of control” clauses, which often require cashing out lenders if a company gets new owners, loom large.
One way to avoid this expense is a “minority recapitalization,” selling a small stake to harvest some profit. KKR did that with online media company Internet Brands last year, bringing in new money from investors including Warburg Pincus while retaining its majority position.
Such deals can crystallize a valuation without a control premium or debt refinancing. The Internet Brands recap valued it at $12 billion, 12 times what KKR spent on its initial investment in 2014, according to Reuters.
What’s more, an existing holder rolling into a deal can sometimes avoid the change-of-control provision. Clayton, Dubilier & Rice last year revisited Cornerstone Building Brands where, after investments stretching back to 2009, it held a 49% stake. In March, it struck a $5.8 take-private of the company without triggering a change of control. Where feasible, it’s a clever work-around.
THE MATH WHIZ
Buyout loans are typically sized as a multiple of a company’s expected earnings. Grow them and borrowing capacity may rise, too. The alchemy of synergies can help.
Combining two companies with $200 million bottom lines adds up to $400 million. Dealmakers prefer abstract math, using promised cost savings or revenue uplift, that produces a $500 million sum.
Private equity firms investing through a company they already own can use this borrowing edge. If it works, great. In this market, however, lenders may be uneasy letting companies borrow against theoretical profit.
THE HIDDEN STASH
If new debt is scarce, why not tap unused wells of it? Delayed-drawn loans are common in packages extended by non-bank lenders, giving a company extra borrowing capacity that kicks in later for another acquisition.
Many were provided during better times, when over-eager lenders issued delayed-draws lasting up to two years and which represent about a quarter of a total loan. It’s a finite resource, but every little helps.
THE DELAYED GRATIFICATION
If leverage isn’t available today, plan for some tomorrow. Private equity firm Thoma Bravo’s $2.3 billion deal for cybersecurity company ForgeRock (FORG.N) in October used no debt. The deal terms allow changes to the capital structure later.
Alternatively, a buyout target can help finance the takeover. When Blackstone (BX.N) agreed to buy control of Emerson Electric’s (EMR.N) climate technologies business in October for $14 billion, the seller provided $2.3 billion in the form of a note ranking senior to existing and future debt and including stiff protections.
Both methods are sub-optimal for anything but the short term and represent a precarious expectation that debt markets will recover swiftly enough for a quick refinancing. The lure is that buyers may be able to swoop at depressed valuations that might otherwise rebound later.
THE SECOND-HAND SHOP
Buyout barons’ own backers also face capital shortages. Limited partners – the pension funds, university endowments and others who provide equity – have less to invest. Lower valuations for publicly traded assets leave them with too much relative cash in private markets.
Reshuffling assets is one solution. Limited partners can sell stakes in old buyout funds, putting the proceeds into new ones. And a buyout shop can swap a portfolio company from one fund into a so-called continuation fund it controls. This market has exploded, with more than $100 billion of transactions last year, according to investment bank Setter Capital.
A twist is the “stapled” secondary. An old asset or fund stake goes to a new investor, who pays in part by putting money into a new fund run by the selling private equity firm. Some 15% of 2022’s direct secondary transactions were structured in a way that typically involves a staple, up from 8% in 2021, Setter Capital reckons.
This money comes at high cost. Stapled secondaries sell at deeper discounts than regular secondaries. Besides putting private equity firms into weaker negotiating positions, the competing incentives also threaten conflicts of interest with limited partners.
...THERE’S A WAY
If the U.S. Federal Reserve avoids engineering a recession, private equity should be able to revert to its tried-and-true formula soon enough. In the meantime, using all equity or accepting secondary-market discounts look like less preferable stopgap measures.
Alternatively, taking advantage of cheaper valuations by creating temporary ownership structures or sidestepping costly contractual terms should tide buyout barons over with less risk.
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(The author is a Reuters Breakingviews columnist. The opinions expressed are his own. Refiles to fix spacing between sections.)
