Should Private Equity Firms be underwriting to a downside case?
“Very dangerous times in global markets” -Paul Singer (Elliot Associates)
“There’s only so much you can squeeze out of a debt cycle and we’re there, globally.” -Ray Dalio (Bridgewater Associates)
“If think it is very dangerous in the market right now. If they don’t raise rates, It think we’re in a major bubble.” -Carl Icahn (Icahn Capital)
These are all direct quotes from some of the best investors of all time earlier this week at the Delivering Alpha conference. (I encourage you to watch those videos if you haven’t already.)
The United States has experienced an economic recession on average every seven years since WWII. Although financials back to the last recession is still common diligence ask, it has now been over 7 year since June of 2008. (Yes, it is hard to believe it has been so long) Whether you believe there is a recession to come in the next few years in a topic for another blog post. One thing seems certain, we will raise interest rates. As a result this will drive down asset prices. These factors coupled with a slower GDP growth of ~2% domestically should equate to a slower projection case when analyzing prospective investments. So has private equity viewed the landscape this way?
It appears to be just the opposite. Average LBO purchase price multiples exceeded 10x EBITDA. This officially surpasses the 9.7x peak that we saw in 2007. With purchase prices at a new peak, it think it is safe to assume that private equity firms are not orienting enough of their investment committee discussions toward downside cases. Instead it seems that the we as an industry are underwriting the investment thesis of buy high and sell higher. Displaying an amazing case of amnesia to 2007 when investments underwritten with that mentality in large part diminished fund returns. To pay top such a steep multiple
This wouldn’t be the first time that the pressure to deploy capital in a timely manner has taken precedent over structuring quality deals. If the race to deploy capital continues to take precedent over prudent investing, it will likely lead to a lower return for the asset class. On the other hand, forward thinking firms should take advantage of those players that are not focusing on the downside exposure by putting quality portfolio companies up for sale to fetch top dollar in the process.
The below “paper LBO model” shows that it requires a private equity firm to grow EBITDA at a CAGR of 4.5% to make up for a 2 turn deterioration in multiples. For the simplicity of the model, we assumed that 100% of EBITDA is used to pay down debt. (obviously not realistic given other fixed charges such as maintenance capital expenditures, but works for our purposes here)
The other thing that firms must think about is the how challenging it will be to grow a business through an economic downturn, unless you are investing in a counter cyclical business. It is very likely that you will see a decline in EBITDA along with your deterioration in exit multiple.
In conclusion, I think it is a at least worth dedicating more time in investment committee meetings to what life looks like in a downside case.