A decade of recovery for private equity by Justin Knight

In essence: private equity (PE) refers to ownership of a company that is not publicly traded. However, since the boom of transactions funded by significant proportions of debt during the early 1980s, the term has come to describe a firm which pursues this particular type of investment strategy.

A Leveraged buyout (LBO) is a type of acquisition whereby the funding is primarily in the form of debt (typically in the region of 60-70% of the total acquisition cost). The aspect of an LBO which renders it such a fundamentally unique technique is in fact not the proportion of debt used to fund the transaction, but rather; the source of debt. Many traditional acquisitions involve significant leverage, however their debt is typically written in the books of the parent company attempting to make the acquisition. On the other hand, when a PE firm performs an LBO, it actually uses the assets and cash flows of the acquisition target itself as collateral for the debt; giving rise to many benefits over the traditional technique.

One obvious benefit of performing an LBO is the significantly inflated purchasing power of the PE firm compared to what its balance sheet might suggest. Due to the financing coming directly from the target company, there are fewer immediate restrictions on the amount of capital that can be raised. Additionally, the tax-deductible nature of the debt means it can act as a tax shield; allowing the firm to enjoy a relatively low cost of capital compared to if the firm had financed through an immediate equity issuance.

PE firms adopt LBOs as a part of their high-risk, high-profit investment strategy. The premise of the strategy begins with the PE firm identifying a business which they consider undervalued, or at least one whose value has obvious potential to be increased. Following the identification of the target, the PE firm attempts to acquire as much of the outstanding equity as possible through the placement of an attractive bidding offer to the current shareholders. Over the course of the next decade, the firm then ‘repackages’ the acquired target; usually through restructuring of key management personnel or methodologies. The aim of the repackaging process is generally to increase overall efficiency, and therefore allowing them to sell it back to the public at a higher price.

The last decade has been notoriously slow for the private equity industry, as the asset class has tried to recover from the colossal impact of the financial crisis – where the total PE deal value dropped to less than one-third of what it was in the year prior to the crash. In an industry that revolves almost exclusively around the investor confidence and the market for debt, it was no surprise that times of extreme uncertainty and minimal cheap debt availability saw the volume of transactions tank accordingly.

Going by total deal value; the PE industry had fully recovered to its pre-crisis state by 2017. However, it would be naïve to quantify the state of an industry based off of raw transaction volume alone. Another key metric that can be analysed is the average price of the PE firms’ acquisitions. In order to account for the size of businesses (and bearing in mind that some of the most fundamental valuation techniques involve forecasting future cash flows), the multiples approach is a common method to determine sensible prices for similar transactions. In 2016, over 50% of PE purchases transacted at over 11x earnings before interest, tax, depreciation, and amortisation (EBITDA). Prior to 2008, any double-digit EBITDA multiple was considered unusually high. Nowadays, PE firms are being forced to pay more and more for acquisitions relative to the cash flows they derive from it – leading to the idea that we are in the early stages of a PE bubble.

Although Blackstone’s recent $20bn acquisition of Refinitiv, Reuters’ FinTech arm shows the industry is on the road to recovery – figures comparing the proportion of held capital that PE firms use quarter-on-quarter make it clear that the industry is not where it once was. Ultimately, one of the main determinants of the future success of the industry will be the evolution of the potential bubble we are in. Alongside this, it will be equally important for PE firms to generate greater returns on investments; perhaps through the successful penetration of emerging markets.

Justin Knight

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