The wave of the leveraged buyout has come and gone like an ocean tide. The once lucrative takeover specialists that haunted public and private markets looking to acquire undervalued companies in the blink of an eye will have to go dormant for the time being. Two key factors have underpinned the rise and fall of the buyout bonanza: undervalued companies and cheap capital. Following the 2008 financial crisis, many corporations traded at significant discounts to their fair market value, allowing investors to buy in at favorable prices. Secondly, the crash resulted in reduced consumer spending, and as a result borrowing rates dropped in an effort to stimulate the economy. Hence, for the last number of years, private equity firms have had access to cheap capital, which has enabled them to leverage significant debt in an acquisition at a reasonable cost of capital. In addition, it gave them financial latitude to pay high premiums for businesses they decided to pursue. Private equity firms differ from traditional institutional or retail investors, as they do not actively invest in public companies; instead they take companies private. The idea behind a leverage buyout is that it allows equity firms to purchase companies using large amounts of debt, or essentially someone else's money (hence the word "leverage"), leaving little of their own equity at risk. However, buyout or takeover specialists do more than just that; they revamp business models, streamline operations, and divest unprofitable operations. These specialists do it all with the hope of selling it back to the public markets or other investors in the near future. Moving forward however, private equity firms may have difficulty finding attractive investments given valuations are near historical highs, and the ability to access credit markets is becoming increasingly difficult.
Since the 2008 financial crisis, takeover prices have increased dramatically due to the availability of cheap capital, which has fueled the appetite of buyout firms as well as the number of possible acquisition targets. When interest rates are low, private equity firms are able to load large amounts of debt on company balance sheets without exposing the corporation to too much financial risk. Minimizing their initial upfront investment allows them to increase returns through the use of leverage while reducing potential losses. The problem that private equity firms currently face is that the recent history of access to cheap capital is about to be squeezed. Since the financial collapse, buyout funds have performed quite well, as they were able to acquire quality companies at discounted prices. Takeover specialists typically hold onto investments for 4-7 years, which means they have to be fairly certain about their future selling price given that it accounts for a large proportion of the return. In the world of finance however, companies are usually bought and sold based on multiples; all one needs to know about multiples is that they are a measure of the overall quality and profitability of a business. Typically, when interest rates are low, metrics (based on multiples) tend to increase, as companies are more profitable and investors have access to cheap capital for investments; the opposite also holds true when interest rates are high. Since private equity firms buy and sell businesses based upon these interest rate sensitive valuation indicators, they may struggle to find investments that will not experience multiple compression moving forward.
*The availability of cheap capital has resulted in a large increase in company purchase prices.
There are many factors that can drive value when evaluating potential takeover targets. Typically buyout funds look for businesses with large tangible assets bases, a steady cash flow profile, a defensible position within the market, and the ability to increase cash flow through revenue growth or cost cutting techniques. With minimal economic growth seen across North America over the past couple of years, many corporations focused on improving contribution margins given the limited increase in consumer spending. The rise in profitability and stream lining of business operations has resulted in a reduction of public companies that present themselves as attractive investments. These overarching negative trends within the industry have resulted in a rise in investment holding periods, as it is taking longer to recoup initial investments. As previously mentioned, future selling prices account for a large proportion of returns, which leads to greater uncertainty when investment-holding periods rise. Given the large ambiguity seen amongst the global economies with respect to GDP growth and rising interest rates, firms are now more hesitant about entering into investments. This is not to say that leverage buyouts are gone forever - the opposite is in fact true. Once the economy completes its next economic cycle, businesses will become cheap along with capital again, leaving private equity firms to take advantage once again.
As businesses become more expensive within North America and market volatility increases, many buyout firms have started to look overseas in Europe and the U.K, as the softer market has resulted in attractive valuations. The large rise in US company prices has led to firms increasing the amount of leverage and equity used in transactions, exposing them to greater risk. The market volatility seen in 2015 and 2016 has made it extremely hard for buyout firms to access credit in order to finance these purchases, which is why firms are keeping capital on the sidelines - currently at all time high of $277 billion within North America. ONEX, a Toronto based private equity firm, along with many other firms have recognized this trend, and have started to invest significant capital into the Euro zone. In early 2014, ONEX acquired U.K based Tomkins for $5.4 billion, marking their first major acquisition overseas. Since then they have made multiple investments abroad totaling over $5 billion, as they believe that the European market presents attractive investment opportunities relative to the North American market.
Economic cycles will come and go, and with that will come a wave of leveraged buyouts. The post 2008 financial crisis led to many acquisitions by private equity firms, as discounted valuations accompanied by low costs of capital presented attractive investment opportunities. Today is a much different scene as company valuations have skyrocketed, making it difficult to purchase companies without applying too much leverage and exposing large amounts of equity. Stagnant GDP across the globe has resulted in minimal revenue growth opportunities, which is why companies have focused on improving margins through the use of cost cutting - this limits potential buyout candidates. The volatility seen within credit markets has made it extremely difficult to finance these elevated purchase prices, which is why many private equity firms will start to look overseas in softer markets. Leverage buyouts will not be gone forever; similar to the ice age witnessed millions of years ago, it is only a temporary event that will spark a new wave of buyouts.