Morning web surfing led me to an article about private equity
Nowadays, PE-owned business are buying at higher valuation and at more debt. Their companies sees slower revenue growth, contracting margins, and declining capital expenditure as a percentage of sales compared to their public market counterpart. This is due to reallocation of profit toward servicing debt rather than reinvesting the profit within the company to achieve higher long term growth.
The market is flooded with capital. First is because of cheap debt can lead to cheap capital. Then again, even without debt, market might be too optimistic so they overinvest in the private equity market. The number of good companies in any given year stays roughly the same, or maybe growing by some rate. But the availability of capital grows at a much faster rate. With less company to buy and more capital to buy with, the purchase price goes up. Simple supply and demand mechanism at work here. Private equity is price sensitive because of the use of debt. Higher prices require more debt, leading to higher interest costs and higher risk of bankruptcy for its portfolio companies.
“In 2007, private equity debt levels reached 5.2x ebitda. Today, they are at 5.8x ebitda, and they have been above 5.2x every year since 2013. The 2007 vintage deals did not end well for investors. Today’s higher-priced and more leveraged deals could end even worse.
These levels of leverage leave companies with no margin of safety. Most companies’ cash flows are too volatile and unpredictable to sustain high debt levels for long.In addition, the recent tax reform caps interest deductibility at 30 percent of ebitda, which for most firms translates to about 5x ebitda of debt. This will be particularly problematic for highly leveraged firms, especially in any downturn when ebitda declines. Those that are lucky enough to grow will be fine, but companies with large interest payments and looming debt maturities cannot invest for growth.”
Private equity is more financial wizardry than it is operation streamlining. It’s easier to change the capital structure of a company in such a way that the company will be forced to service additional debt without doing anything significant improvement in the underlying operation and still got a return from exiting the investment. Financial engineering is just simple Excel modeling to find out the optimal size and kind of debt to ensure maximum shareholder value. Operational streamlining requires actual work of different complexity and it is a very industry-specific work that need real expertise.
“Debt led to bad management decisions and ultimately bankruptcy of the U.S. company
The biggest assumption behind a debt-financed takeover is that the company can cut costs to improve cash flow and thus pay the interest. But behind that assumption is an even bigger assumption. That the marketplace won’t change dramatically. The KKR and Bain Capital leaders assumed they could shrink Toys R Us in a way that would lower operating costs. They also assumed they could sell some under-utilized assets to raise cash. They did not assume they would need contingency money if competition, and the marketplace, changed in some unplanned way. That contingency money should have been used to invest in innovation to stay relevant. But hard to do that if company’s cashflow is beholden to service debt. There are not margin of safety in debt-loaded company.”
One more thing. The use of debt encourage buying things that are otherwise not affordable. This can make bubble inflate faster, and bursts hurt more.
Then, can the non-use of debt align the incentive of the private equity to instead reinvest the capital to organic growth?
“Instilling a sense of fiscal restraint early, where growth comes from disciplined customer acquisition, not a venture capitalist’s checkbook, lead to more sustainable businesses
Our hypothesis is that too much capital over time creates a culture that substitutes cash for creativity and operational discipline. Big balance sheets allow companies to grow inefficiently, to paper over problems with headcount and spend, rather than confronting the core engine of value creation. Having less money forces a management team to make hard decisions early on and to cut off potentially wasteful problems that otherwise could linger indefinitely. This efficient ethos becomes part of the long term culture of productive performance that is difficult to infuse in the enriched companies that never operated in a constrained way.”
Even venture capital which only employ equity faces the same problem of less efficient capital allocation. This should even more true for the debt-armed private equity, which make cost of capital cheaper, thus oversupplying capital.
Therefore, private equity must be imagined. There should be more market research, more technological innovation, more operational optimization, and anything that will support real growth by serving the economy better. Not just some strangling the already-struggling companies and leaves them dry.
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