According to the recently published Bain & Company Private Equity Report 2020, private equity firms had $ 2.5 trillion in dry powder at the end of 2019.
Private equity firms are actively looking for M&A deals and their demand for acquisition finance drives open debt markets. The fluctuations in the markets have produced many willing buyers and willing sellers. Interest rates are still relatively low. This is the time for private equity to buy low and show value in identifying and analyzing investments.
Large investments are already being made. Saudi Arabia’s sovereign wealth fund bought an 8.2% stake in Carnival Cruises after the price fell 90%. Many see this time as a buying opportunity and more business is done.
In general, private equity firms do not make pure cash purchases. According to Bain, 75% of buyout deals in 2019 had a debt multiple of 6x EBITDA or higher. In the US, the average purchase price for a buyout was 11.5 times EBITDA. The purchase price was roughly financed with 50% cash and 50% debt. As the $ 2.5 trillion in dry powder is invested in acquisitions, it will add another $ 2.5 trillion in debt.
The duration and pricing of debt will be more conservative
Lenders are looking for shorter term loans as the long term horizon is unclear. Long-term liquidity premiums will also reduce borrowers’ appetites. The term of office is expected to be three years or less. The market is not ready for five year loans. The pricing has also become more conservative and is 50 to 100 basis points above the price level of just four months.
The leverage will be less
In the past, banks may have been happy with loans at 2.5 to 3.5 times EBITDA, but now they recommend 2 to 3 times. Part of the reason for this is that EBITDAs are less predictable today and many companies will have a sharp drop in profits. IMF forecasts that the world economy will contract by 3% in 2020; That means lower profits for most companies.
Banks are reluctant to lend after releasing $ 124 billion lines of credit after the crisis
The COVID-19 crisis has affected banks’ lending. The banks were the villains in the 2008 crisis when they shut off the cash flow. This time the banks had a more positive initial reaction. CFOs rushed to ensure liquidity and took over $ 124 billion on their credit lines in the first month of the crisis. Banks allowed line borrowing to support their existing customers. In view of the already high capital investment, however, the banks are hesitant to grant further loans. So bank lending has stalled.
Governments lean against with incentives; Banks can sit back and relax
The CARES act arranged government-secured loans and the Fed stepped in to buy corporate bonds. When the government leans back, banks see this as an opportunity to sit back. While some banks acted as conduits for government-supported stimulus lending, lending declined without reference to the stimulus programs.
Crisis drives banks to cut back and limit unprofitable businesses
The crisis was also the impetus for all companies to curtail less profitable relationships. Banks are closing low-profit businesses, leaving unattractive markets and cutting jobs where they cannot compete. For example, Bank of America, JP Morgan and Goldman Sachs are all giving up market shares in Europe, where their margins were not as attractive. These are responsible acts for lenders during this crisis, but it will create a tough market for borrowers.
A deterioration in creditworthiness makes underwriting difficult
Another discouraging trend is the decline in creditworthiness. Given the uncertainty about when and how the recovery will take place, credit rating agencies are considering downgrading ratings for a wide variety of companies from ExxonMobil to Zara. Underwriters are reluctant to lend with so much credit risk. One underwriter said he saw a lot of uncertainty in the bond syndication market as “nobody we can sell today”.
But “debt will come back.”
A well-placed source with insights into big players like JP Morgan, Morgan Stanley, Deutsche Bank and smaller regional banks predicts: “Saudi Arabia’s acquisition of Carnival clearly shows that investors see value in even the most distressed assets. PE firms will also make opportunistic acquisitions and the successful combination of M&A and acquisition leverage will return. The first few dances can be more cautious and conservative, with less leverage and higher costs. When the new normal comes in sight, leverage will increase, costs will decrease and volumes will increase. Active investors will spend their long-awaited days in the sun. Bankers will resume their fees. The debts will come back. “