Recapitalizations have played a key part in fuelling the leveraged buyout (LBO) boom.
For private equity (PE) groups, the ability to extract large dividends early in the life of their investments not only de-risks the deal, allowing them to hold on to portfolio companies for longer; it also—thanks to the way returns are calculated—allows them to boost their reported returns.
But does a warning from Moody’s spell trickier times ahead for recaps?
In a paper published this week, the US ratings agency warned that investors are providing too much debt on easy terms—and that this liquidity is encouraging buyout groups to refinance rather than de-leverage their investments. In fact, many are using recaps to take leverage levels up.
Last year, European LBO firms extracted a record €8 billion (Rs46,400 crore then), according to Fitch, another ratings agency. As a result, leverage levels post-recap were an average of 6.4 times Ebitda (earnings before interest, taxes, depreciation and amortization), up from 5.5 times at the initial investment.
What’s more, the average time taken to complete a recap has fallen from 29 months in 2004 to just 20 now.
But even before the Moody’s warning, there were signs that investors may be pushing back. After all, a highly-leveraged recap leaves credit investors facing all the downside risk, without sharing any of the upside.
An over-aggressive refinancing has already led to the failure of one prominent PE-owned business—UK retailer Focus DIY. Last month, KKR failed to win support for a €1.1 billion refinancing of Dutch retailer Maxeda. The buyout group has now added a new covenant in an attempt to get the deal away.
Meanwhile, leveraged loan prices have fallen in the secondary markets in both the US and Europe in the past few weeks, due to a combination of subprime jitters and rising interest rates.
Some investors are starting to pull out of the credit markets altogether. And spreads on new deals are widening, which makes it more expensive to refinance.
Of course, these may be just straws in the wind. So far, the credit markets remain open for recaps.
But if credit conditions worsen, making the recap option harder, PE would lose an important source of the juice that has been fuelling its recent returns.