Tuesday, December 4, 2018

What Hath Private Equity Wrought?



Source: LCD, www.leveragedloan.com

After the last financial crisis, the Federal Reserve warned banks that most companies should not carry debt levels above 6x EBITDA. Unfortunately, that hasn't stopped the mania in private equity.

Today, private equity companies buy companies at 10-11x EBITDA. From the second quarter 2018 press release for Web.com (pictured above), its net debt to EBITDA was approximately 12x. Deals like Refinitiv ($17B buyout), and Akzo Nobel ($11.7B), otherwise known as "jumbo LBO's," have contributed to the increasing size of US LBO's, now nearing pre-crisis peaks. The third quarter of 2018 saw an average size of approximately $1.75 billion in US LBO's, somewhat comparable to the $2.1 billion peak in 2017.


Source: TM Capital, Leveraged Lending Market Report October 2017

At present, US loan funds have an AUM of almost $185 billion, which is a 68% increase since June of 2016. Despite this, growth has plateaued in recent months. The recent outflows of equity capital from leveraged loan funds could mark an inflection point. They are occurring at a time when leveraged loan issuance is at its highest, which could signal that a liquidity dry-up is eventual. Investors have pulled nearly $1.74 billion from loan funds, which marks the second biggest outflow in the past four weeks. This follows the $1.5 billion outflow in mid-October.

What does this mean from an Austrian standpoint? There are two morals: first, everything comes at a price, and second, everything has consequences. There is only so high a price that private equity firms can pay when taking another company over. And there is only so much leverage that can be placed on a company. The LBO graveyard is littered with examples from past corporate debt bubbles: RJR Nabisco, United Airlines, Texas Power (Energy Future), et cetera. The consequences, no matter how far they can be postponed, always catch up. Mises once commented that the second class of recipients of inflation are the investor-class, who receive it in the form of asset inflation in stocks and real estate. LBO deals are no exception, and despite their "success" from the credit-fueled binge, their end will be met. We're already seeing reflexivity assert itself. As Stein's Law states, "If something cannot go on forever, it will stop."