Thursday, March 15, 2018

Private Equity Braces For Downturn?

Max Bower of Reuters reports, Private equity firms brace for downturn:
Senior participants are warning that today’s market could be as good as it gets, despite a robust global economic backdrop and buoyant mood in the private equity and leveraged loan markets.

Comparisons to 2007’s pre-crisis conditions are becoming more common and industry figures are debating whether today’s robust conditions constitute a bubble, as purchase prices rise, jumbo buyouts proliferate and deal terms become more aggressive.

“I think we’re now in bubble territory,” said Frode Strand-Nielsen, founder of Nordic private equity firm FSN Capital.

Leveraged buyout purchase price multiples hit a record high of 11.2 times average Ebitda in 2017 and average buyout sizes also hit a new record of US$675m in the third quarter of 2017, up from 10 times in 2016, according to a recent report by Bain & Co.

Increasingly large buyout loans have been announced this year, including Blackstone’s US$20bn buyout of Thomson Reuters’ Financial and Risk division (TRI.TO), and the upcoming €10bn carve-out of Akzo Nobel’s specialty chemicals division.

Blackstone is buying a 55% stake in Thomson Reuters’ Financial and Risk unit, which includes LPC.

Strong debt markets are currently seeing good investor demand, but private equity firms are targeting companies that they can take through a recession, Gregor Bohm, co-head of Carlyle’s European buyout business, said at Berlin’s SuperReturn conference.

“You have to sell all the companies that you don’t want to hold through a recession,” he said.

The next five years could be a difficult environment for private equity and leveraged credits, Strand-Nielsen said, particularly as buyouts that have been financed with cheap debt will get more expensive if interest rates rise.

“There’s a lot of financial engineering, which usually indicates we’re going into a concerning environment,” he said at SuperReturn.

The specter of monetary tightening as the European Central Bank ends its Quantitative Easing program is consistently highlighted as the biggest risk facing the market this year, among many, as global tensions rise.

SAME BUT DIFFERENT?

While private equity firms and bankers are aware that they are at the top of the market, benign borrowing conditions could persist for some time, allowing borrowers to lock in cheap debt.

“Borrowers are enjoying peak funding conditions,” said Ed Eyerman, head of European leveraged finance at Fitch in London.

Comparisons with 2007 overlook the fact that the leveraged loan market has fundamentally changed due to covenant lite lending - which did not exist a decade ago - and a larger and more diverse institutional buyside.

Although the lack of covenants is causing concern, bankers point to Spanish fashion retailer Cortefiel’s 2014 amendment and extension of €1.4bn of debt and 25% covenant headroom increase.

This bought time for the operating business to improve and allowed Cortefiel to return to the debt markets last year, but other companies may not be so lucky.

“Cortefiel was the poster child for cov-lite lending but you can’t assume all will do that well,” a market analyst said.

Co-president Scott Sperling said that Thomas H. Lee Partners is focusing on less cyclical growth businesses which are better positioned to weather a downturn that could have a similar magnitude to the last financial crisis.

“It’s certainly not a brave new world that includes no cycle,” he said. “Our base case incorporates a recession of the size of 2008. The swings can be reasonably violent so you have to recognize how that could affect capital structures.”

CORRECTION INEVITABLE?

The global macroeconomic backdrop is also stronger than 2007 and private equity firms are continuing to benefit from broad-based global economic growth, Sperling and Eyerman said.

Interest rates are rising, but are expected to stay lower for longer than before the financial crisis, which is unlikely to affect companies’ debt-servicing ability in the short term.

Fixed charge cover ratios, which measure how comfortably businesses can meet operating costs, are also higher in leveraged companies than before the crisis.

The type of companies borrowing has also changed with the rise of software and business services with fewer assets and higher free cash flow margins, that require less onerous credit protections, Eyerman said.

“They don’t have the capex and fixed costs of pre-2007 leveraged credits in sectors such as auto supply and building materials,” he said.

Despite lower debt servicing costs, some still think the market’s record nine-year bull run is simply delaying the inevitable correction, which will only make it more painful.

“We’re watching a movie where we know what the ending is,” said Guthrie Stewart, global head of private investments at PSP Investments. “Just not how long it is until we get there.”
It's interesting the article ends with a quote from Guthrie Stewart, global head of private investments at PSP.

PSP Investments just announced a deal where it will acquire a significant minority in Learning Care Group:
The Public Sector Pension Investment Board (PSP Investments) has made a significant equity investment in Learning Care Group (US) Inc.

American Securities LLC, which acquired Learning Care Group in May 2014 in partnership with the company’s management team, will remain as controlling shareholder.

Novi, Michigan based Learning Care Group focuses on the care and education of children between the ages of six weeks and 12 years. The company’s national platform of more than 900 schools has the capacity to serve more than 130,000 children in 36 states, the District of Colombia, and internationally. Learning Care Group operates under seven distinct brands: The Children’s Courtyard, Childtime Learning Centers, Creative Kids Learning Centers, Everbrook Academy, La Petite Academy, Montessori Unlimited, and Tutor Time Child Care/Learning Centers.

“Our investment in Learning Care Group is a great example of our strategy to back market-leading businesses with strong long-term fundamentals and world-class management teams,” said Simon Marc, Managing Director, Head of Private Equity, PSP Investments. “With its high-quality services, Learning Care Group is uniquely positioned to further capture growth in the early childhood education market. We are excited to partner with American Securities—with its impressive industry knowledge and a history built on true partnerships—to support Learning Care Group’s management team, which has positioned the company for the next phase of growth.”

“We are pleased to be supported by PSP Investments to continue Learning Care Group’s growth trajectory,” said Kevin Penn, a Managing Director of American Securities. “We look forward to working with them at the board level to further develop the company’s market leadership.”

“We are excited to partner with PSP Investments and believe their international expertise will be invaluable as we further build our business outside of the United States,” said Barbara Beck, Chief Executive Officer, Learning Care Group. “At the same time, this new investment and American Securities’ continued support will enhance our ability to accelerate Learning Care Group’s multiple levers for growth in the United States.”

Arnold & Porter Kaye Scholer LLP acted as legal advisor, and Morgan Stanley and BMO acted as financial advisors to Learning Care Group. PSP Investments’ advisors were Barclays (financial) and Sidley Austin LLP (legal).
You can read the press release PSP put out on this deal here.

Details weren't provided but it's clear PSP is investing in a market-leading business with strong long-term fundamentals and it's a recession-proof industry. In other words, this is a defensive play in private equity.

It was also just announced that a consortium led by BC Partners and including the Public Sector Pension Investment Board (PSP Investments) and Ontario Teachers’ Pension Plan has completed previously announced acquisition of CeramTec Group, a leading international producer of technical ceramics, specializing in the development, production and distribution of components and products made from ceramic materials.

Just by looking at the nature of these private equity investments, it tells me a lot about where PSP and other large Canadian pensions are committing capital in private equity and where their risk appetite lies at this point of the cycle.

And I don't blame them. I recently wrote a lengthy comment on froth in private equity, one you should all take the time to read carefully.

Everything is overvalued right now in public and private markets. Record low rates have driven investors to take bigger and bigger risks to attain their return targets, pumping up valuation to extreme levels.

However, unlike many who see rates rising as inflation creeps into the economy, I see record low rates persisting for a very long period. Too many people still don't understand the inflation disconnect.

In theory, this should bode well for risk assets but I've got some bad news for those of you who think the party in private equity and all risk assets will last a lot longer if rates stay low for a lot longer.

As I keep warning my readers, we are one major deflationary shock away from a significant global downturn, one that will push US long bond rates to a new secular low and clobber risk assets across public and private markets.

This isn't good news for pensions plans as both assets and liabilities will get hit hard and pensions already suffering from chronic deficits will be particularly vulnerable during the next deflationary crisis.

One thing caught my eye from the article above:
Co-president Scott Sperling said that Thomas H. Lee Partners is focusing on less cyclical growth businesses which are better positioned to weather a downturn that could have a similar magnitude to the last financial crisis.

“It’s certainly not a brave new world that includes no cycle,” he said. “Our base case incorporates a recession of the size of 2008. The swings can be reasonably violent so you have to recognize how that could affect capital structures.”  
Imagine, their base case incorporates a recession the size of 2008. What if it's worse next time around and much more protracted? Lots of recent vintage years in private equity are going to record serious losses for their investors.

And it's not just private equity that worries me. Cheap money has fuelled the bubble in venture capital and the recent fraud charges against Theranos founder Elizabeth Holmes are just the tip of the iceberg. There is a lot more nonsense we never hear about with all these unicorn start-ups.

Lastly, a giant retailer of children's toys announced its liquidation today. Below, Perry Mandarino, B. Riley FBR, discusses the troubles for Toys R Us as the toy retailer liquidates its holdings.

Interestingly, this was another victim of private equity's asset-stripping boom but to be fair, this company had so many issues that I don't think ten David Bondermans working full-time to turn it around would have succeeded.

And this morning on CNBC Squawk Box, Richard Bernstein, Richard Bernstein Advisors, and Jason Trennert, Strategas Research Partners, provided insight to what's likely driving market volatility.

Given my views on the inflation disconnect I disagree with Rich Bernstein  and would categorically say large public pensions are much better prepared for inflation than deflation.

Right after this segment, however, they both discussed how private equity is increasingly betting on public companies, taking them private, and how the fate of private equity is inextricably tied to public equity markets and the illusion of low volatility in private equity is just that.

Unfortunately, the clip below stops right before they entered that conversation on private equity.


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