What Every PE Expert Needs To Know Now and For 2012
Where will liquidity come from and who will be providing it?
October 17, 2011
Now that we have all lived through the Credit Crisis, what do private equity professionals need to know in order to successfully navigate the U.S. financing and capital markets now and in 2012, where will liquidity come from and who will be providing it?
Private Equity Investing Has Become A More Difficult Business In This Decade Than In The Last 30 Years
Market volatility, changes in lending and new regulatory requirements have made private equity a more difficult business in 2011. If we look at the period from 1981 to 2000, the overall market maintained an upward trajectory and the use of leverage made perfect sense during that time. In 1981, debt created returns because we were operating in a high inflation environment, with interest rates that only moved lower for the next 10 years. In a sense, you could buy a business with absolutely no growth, leverage it with 90% plus debt, watch inflation grow by 10%, and triple your money. That was the story of the 1980s.
In the 1990s we had the greatest bull market of all time: from January 1990 to the end of 1999, you could leverage just about anything and post an attractive return. If you just levered the stock market, for example, you would have been a leading fund manager. However, going into this decade of the 2010s, investors will have to navigate a choppy, up-and-down market and not rely on an upward business cycle to bail them out. With inflation at least checked for now, private equity fund managers are going to have to earn their stripes.
Banks Make Money Today By Not Lending
Ever wonder why banks do not have huge lending appetites right now? Consider this - Thomas Hoenig, President of the Federal Reserve Bank Kansas City, said recently that the Federal Reserve's policy of holding interest rates near zero is a subsidy for large banks that redistributes wealth from savers to debtors. Testifying before the House Subcommittee on Domestic Monetary Policy, Hoenig said banks can borrow at .25% and buy Treasury bonds that yield around 3%. "It provides them a means to generate earnings and restore capital, but it also reflects a subsidy to their operations," Hoenig said. "It is not the Federal Reserve's job to pave the yield curve with guaranteed returns for any sector of the economy, and we should not be guaranteeing a return for Wall Street or any special interest group," Hoenig added. With a "risk-free" return of 3% leveraged at 10 times, it is no wonder why banks today are not aggressively making new loans.
Unitranche Debt Gains Significant Traction With Middle-market Borrowers
The lack of traditional bank financing, however, has paved the way for new, innovative credit structures favorable to today's private equity sponsors. Unitranche financing, a product provided by Monroe Capital that employs a single blended rate for a combination of senior and mezzanine debt supplied by one lender, has become an especially attractive alternative for financing acquisitions of mid-sized companies.
Unitranche debt provides borrowers with the benefits of flexible capital and a more efficient lending process that increases the speed with which borrowers can execute deals. One-stop lending has become a common method of financing middle-market companies, and many private equity firms and lenders prefer this product over conventional debt structures involving a senior debt provider and a mezzanine debt provider. There are fewer parties to deal with, no inter-creditor agreement issues among lenders and one set of rules for the company.
Rather than having a separate interest rate for senior and mezzanine debt, the unitranche structure employs a single blended rate that averages out the cost of the two forms of capital. The simplicity of working with a single party can also help close deals quicker, an attractive characteristic for firms that value ease of execution and speed. In recent months, Monroe Capital's clients have increasingly requested unitranche with over 50% of our financings involving blended debt.
As Megadeals Lose Their Luster, More Middle-market Companies Are Becoming Increasingly Attractive to Financial Buyers
Private-equity firms of all sizes are increasingly focused on investing in middle-market companies. Investments in this size range demand less capital than larger buyouts and provide greater flexibility when it comes time to exit an investment. In turn, this makes middle-market investing quite attractive at a time when bank lending remains tight. The statistics bear this out: middle-market deal volume is increasing, both in terms of the number of transactions and the dollar value of deals.
