Traditionally, many private equity firms take advantage of cheap debt, leveraging their acquisitions as much as possible. The higher the amount of debt used to buy a company, the better the return in a successful investment.
If a private equity firm buys a company for $25 million in cash and sells it for $50 million, it makes a return of 100 percent. But if it uses $5 million in cash and $20 million in debt, the returns are significantly greater.
But now, some reports show that private equity firms are not taking advantage of all the debt available to them in today’s strong lending environment. There are a couple of reasons why that might be happening.
With company valuations climbing, private equity firms are being more conservative about the amount of debt they leverage against those businesses. Many people believe there’s a recession coming, and private equity firms remember how hard it was to stick within their lending covenants the last time around.
Most business brokers and intermediaries believe the current strong M&A market won’t last much longer. More than four-fifths (83%) believe the market won’t survive through 2020 and a third (32%) say we won’t even make it through the end of 2019, according to the Q4 2018 Market Pulse Report published by the IBBA, M&A Source and the Pepperdine Private Capital Market Project.
I bounced this concern off a local lender who told me the industry is preparing for interest rate risk and that rates are expected to slow or even drop at the end of 2019. Large banks, in fact, already began to retreat in certain lending categories as early as 12 months ago.
On the other hand, private equity might be ponying up more of their own cash in order to fuel their growth plans. Depending on their add-on acquisition strategy and future financing needs, it might not make sense to load a company with a lot of debt right from the get-go.
Valuations are near historic highs and there’s only a limited number of quality deals available. It’s a highly competitive market and private equity might be writing larger checks in order to compete with cash-rich strategic buyers. More equity on the table means less risk to lenders and sellers and a smoother path to getting a deal done.
For Cornerstone, for the deals we represent, we typically see debt to equity ratios of about 50/50 or 60/40. That’s roughly in line with what you’ll see reported in national statistics, and it leads me to a couple of takeaways:
Buyers: If you’re looking to grow through acquisition or purchase your first company, be wary of lenders who tell you they can offer a large amount of debt against your acquisition. Your commercial lending rep may be promising more than they can actually get approved.
And even if you can get in with a low equity stake, it might not be in your best interest. Over-leverage your business and a bump in the road can quickly turn into a mountain.
Sellers: When you sell your business, you can expect to take on some amount of alternative financing. Most sellers will finance around 20 to 30 percent of business value via some combination of traditional seller financing, earns outs, or an equity stake in the new organization.
That means as you evaluate potential offers, you need to look beyond the purchase price buyers are offering. You also need to consider the likelihood that you’ll get paid. Due your due diligence and check the buyer’s track record. Ask to see their “source and use of funds” statement to determine how much equity they are bringing to the table.
Most sellers we talk to are concerned about legacy as well as value. They want to see their company go forward, creating opportunities for their employees and contributing to the community. But substantial leverage can put your company at risk a few years from now. Working with a buyer who takes on a responsible debt load will help cement your legacy and the future of your business for many years to come.
Buyer or seller, either way, the good news is that our lenders in northeast Wisconsin are good stewards of the regional business community. They’ll help you put together a deal that works, without creating undue risk. We can’t necessarily say the same thing about some of the non-traditional lenders operating across the country.
