Banks and other creditors are sticking more of their necks out when funding private-equity players' leveraged buyouts.
Equity contributions to leveraged buyouts have generally remained in the 30%-40% area for a couple of decades, but private-equity firms have recently begun to negotitate contributions of as little as 25% as borrowings increase, one insider says.
"What we are seeing is that for the right deals the magic numbers are getting a little more liberal," said Richard Farley, a partner at the law firm Paul Hastings. "Obviously this is for appropriate credits."
The trend could benefit banking companies, which provide financing and bridge loans to private-equity firms conducting buyouts. Banks also syndicate longer-term loans and underwrite bond issuances.
A 30% equity contribution is still the low end of bond and loan investors' comfort zone for most LBOs. Investors will only consider allowing sponsors to write smaller equity checks for stable companies with dependable cash flows and tangible assets, Farley says. The credit metrics of the individual issuer are more important than the sector it is in, he said.
Farley declined to name any completed LBOs with only 25% equity financing but said he had recently advised on one such deal that fell through after the private-equity firm was outbid by a strategic buyer.
LBO activity is picking up after it came to a screeching halt last summer. For the year to date through May 13, nine high-yield bond deals totaling $8.3 billion have been issued to back LBOs. By comparison, there were $19.7 billion issued via 34 deals to back buyouts for all of 2011. That was the most since 2007's record of more than $50 billion across 50 deals, according to Dealogic.
When private-equity shops write smaller equity checks, they issue more junk bonds — which could be seen as a welcome development in a market that has been starved of supply. But the companies issuing this debt are also riskier because they are saddled with more debt.
"Once you go below 30% [equity contribution], you're taking on a lot of risk," said Steven Kaplan, a professor of finance at the University of Chicago's Booth School of Business.
The LBO market learned its lesson in the late 1980s, when deals were financed with equity contributions of as little as 10%, Kaplan says — a level he described as "crazy" because "there just wasn't enough equity to support the junk bonds."
A 30% equity contribution was the general practice in the 1990s, and contributions have generally remained in the 30%-40% range since 2000, he said. Even in the heady days of 2006 and 2007, these levels did not dip below 20%.
"We had this huge financial crisis and people said these deals would all default and they didn't. Why? Because they were financed responsibly," Kaplan said.
Equity contributions for lower-middle-market LBOs with values of approximately $100 million can be even higher. Such deals are more likely to require a 50% equity contribution, said Jeremy Swan, a principal with the Cohn Consulting Group of J.H. Cohn.
Nevertheless, Swan said he isn't surprised to hear that equity checks have begun to shrink, although he thinks this will be easier for larger LBOs. "I would not expect to see midmarket-and-below deals being done at below 35% equity," he said. "We're still seeing those between 40% and 60% equity."
Blame it on the Federal Reserve's low interest rate policy, which has left investors starved for yield. "There's been a flight to some risk for bond investors," Swan said. "That's created a frothy debt market in the senior debt markets, especially the mezzanine and high-yield markets." At the same time, he said, "there's been a bit of a dearth of quality deal flow, so now there are quality assets on the market and those deals are getting bid up aggressively, and we're seeing a pop in purchase prices."
Swan added that private-equity buyers are only going to be able to get the returns they are targeting if they put less equity into LBOs.
Farley does not view smaller equity checks as a sign of excessive risk, however.
"No one got burned when the musical chairs stopped last summer," he said. "There were a couple of deals that were large and relatively aggressive that people kept a close eye on. There were a number of deals that were flexed to the max … but no one really lost any meaningful amount of money. The fail-safe worked."
Farley compares the high-yield market to runners that have recovered from a pulled muscle. The first few times back on the track, the runners tread lightly, but once they realize they can run without injury, they pick up speed.
For investors, the trend poses a mixture of risk and reward, said Martin Fridson, global credit strategist with BNP Paribas Investment Partners. "It looks like they're going to get some relief in their ability to get money invested, but at the price of some increase in leverage in the deals."