Buyout backdown: Barbarians retreat from the gate

Data InsightDealspeak 18 July

Buyout backdown: Barbarians retreat from the gate

Leveraged buyout (LBO) activity in North America nearly halved between the first and second quarters of 2022, raising questions about where the ‘Masters of the Universe’ – private-equity (PE) firms – go from here. 

In 2Q22, North American LBOs plunged 48% to USD 50.6bn compared with USD 95bn in 1Q22.

Double trouble: Rising rates and higher yields stifle activity

A confluence of factors is putting pressure on the industry, explains Mike Meyer, head of capital markets at Union Square Advisors. The Federal Reserve’s interest-rate hikes, as it struggles to throttle inflation, is a serious body blow. Given PE firms juice their returns by using debt totaling 30% to 80% of a price tag, a rise in interest rates threatens the economics of a deal. The Fed’s Secured Overnight Financing Rate (SOFR), a benchmark used to set interest rates on loans, has leapt to 1.53% from 0.05% in January. 

Another compounding factor is that leveraged loan and high-yield (HY) bond investors are demanding much chunkier yields than six months ago to compensate for greater macroeconomic uncertainty. Many believe a recession is imminent. In the US HY bond market, weighted average yields topped 8.6% in 2Q22 from 5.9% in 1Q22.

Combine these two factors, and the cost of LBO financing has ballooned to 10% in 2022 from about 6%. Extra interest payments impact a portfolio company’s cash flows and the leverage a PE firm can put on a deal, says Meyer.

Counting the cost: Bank losses mount from previous deals

A third factor is that banks underwriting LBOs face steep losses from deals struck earlier this year when financial conditions were better. Banks typically provide LBO financing before selling the debt in the leveraged loan and HY bond markets, often several months later. If credit markets sour during this time, banks try selling that paper at a discount. Average US leveraged loans priced at 92.9 cents on the dollar in June from 96.8 at the end of April. Citrix’s LBO, announced in January, is one such deal causing pain. Banks that promised to underwrite the USD 15bn debt portion face hundreds of millions in losses.

All this has resulted in US leveraged loan and HY bond issuance halving sequentially to USD 88bn in 2Q22 from 1Q22.

With banks putting a stop to underwriting LBOs, sponsors are increasingly turning to private credit markets to finance deals, notes Meyer. That market remains open and includes lenders such as Golub Capital and Ares Management, as well as the financing arms of PE firms like Blackstone and Apollo.

SPAC payback: Tumbling valuations draw sponsor interest

The year’s battered stock markets are creating opportunities for financial sponsors to buy assets at a discount. In late June, Zendesk [NYSE:ZEN] sold to a group led by Hellman & Friedman and Permira for USD 10.2bn, four months after rejecting a USD 17bn offer. 

Many software firms have seen their valuations halve this year to between 5x and 7x, notes Meyer. While this is a staggering slump, it brings valuations down to pre-COVID averages. 

Tech firms, especially those that listed through mergers with special purpose acquisition companies (SPACs), have seen valuations collapse 60-80%. Several are quality firms tarnished by the wider SPAC selloff and are drawing interest from PE firms, adds Meyer. He expects to see sponsors “gobble up” such companies once leveraged capital markets reopen later this year or next. 

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