Private equity woes go beyond deal freezes

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The most visible sign of trouble in the private equity industry right now is one deal after another collapsing. You can’t do a leveraged buyout without the debt, and the funding markets are freezing. But buyout companies face bigger challenges than growing their pool of idle funds.

The turn in credit markets has pushed banks away from underwriting giant debt packages for deals. Lenders who backed the takeover of Wm Morrison Supermarkets by Clayton, Dubilier & Rice LLC last year were unable to sell all loans to other banks and investors before bond yields jumped.

Pharmacist Walgreens Boots Alliance Inc. canceled the £5 billion ($6.1 billion) sale of its UK subsidiary Boots last month. Consumer products company Reckitt Benckiser Group Plc has also considered pausing plans to sell its remaining infant nutrition business, a potential $7 billion deal, with private equity as the obvious buyer.

Certainly, some transactions are still in progress or in the process of being attempted. But they’re usually infrastructure-type, like Deutsche Telekom AG’s cellphone tower business, or small, like UK-based publisher Euromoney Institutional Investor Plc, or special situations, like software company Zendesk Inc. in the United States.

Frozen funding strikes at the heart of the private equity model. And the industry still has a lot of unused dry powder. But there will be a thaw over time and the upside for buyers is that purchase prices are likely to come down.

The big unknown is how long buyers and sellers will find common ground on valuation, and whether falling asset values ​​will fully offset having to fund deals with more expensive debt. . Industry may need to compromise on performance barriers above 20%.

The most fundamental issues relate to past transactions, not new ones.

Buybacks over the past couple of years or so, hit as markets peaked, could become a cornerstone.

The valuation of average U.S. leveraged buyout to earnings, as conventionally measured, has increased 1.8 times between 2000 and 2021, according to consultancy Bain & Co. Rising valuations on the public and private markets allowed private equity firms to exit investments at multiples of the profit they paid. Repeating this trick is going to be tough, making efficiency and revenue gains more pressing priorities to increase the value of the business for sale. But macroeconomic pressures weaken both levers.

Additionally, many private equity portfolio companies will face cost pressures that they cannot pass on to their clients. Leverage can push sick companies into critical condition. When debt has been provided with covenants, lenders may be powerless to intervene until the problems are serious. A well-publicized blowout would remind investors that leverage goes both ways.

Which brings us to fundraising. Investors’ enthusiasm for private assets has allowed companies to raise ever larger funds, thus widening the pool of management fees and enabling them to develop their own businesses. It could be a while before new records are set. As private market valuations catch up to the stock market decline, limited partners who invest in buyout funds should prepare for disappointment.

A sudden slowdown in private equity allocations would hit small and medium-sized buyout companies particularly hard. They were already on the wrong side of a trend that saw investors commit more to fewer but bigger companies. Now the battle will be over a shrinking pie.

So don’t worry about deals that private equity can’t do today. You worry about the performance of the deals they’ve made and where the next round of charges are coming from.

More from Bloomberg Opinion:

• Don’t let private equity make a fool of you: Chris Hughes

• Kellogg Serves Hungry Investors a Snack: Andrea Felsted

• Paulson hits Paydirt again with Porsche of Pianos: Chris Bryant

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Chris Hughes is a Bloomberg Opinion columnist covering the deals. Previously, he worked for Reuters Breakingviews, the Financial Times and the Independent newspaper.

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