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LPC: Private equity firms put more capital, less debt into LBOs

NEW YORK, Aug 26 (Reuters) - Higher company valuations and lenders wary of risky investments are pushing private equity firms to increase the size of equity contributions, or checks, for leveraged buyouts near historic highs in the face of fierce competition from cash-rich corporate buyers.

Leveraged buyouts allow investment firms to make large-sized acquisitions by using a more significant percentage of debt compared to the capital they put in. With a larger equity check, private equity sponsors commit more money, which reduces the risk for debt holders but is less profitable for the sponsor.

The average equity contribution during the second quarter was 45.7%, the highest level since the first quarter of 2012 when the average reached 46.1%, according to Thomson Reuters LPC data. The all-time high was in 2009 when sponsors had to pay an average of 50.3% of the purchase price.

Comparatively, in 2007 equity checks averaged in the low 30% area, making the return on investments more lucrative.

Sponsors have been paying 40%-60% this year out of pocket on a regular basis, according to a banker. Vista Equity Partners this month arranged a US$375m term loan to back a US$1.8bn buyout of marketing software firm Marketo.

“In 08/09 when the debt markets were essentially shut, we saw equity percentages really climb,” said Jeremy Swan, principal at accounting, tax and advisory firm CohnReznick. “The difference now is that the debt markets are still open but not necessarily for every deal.”

Despite the fact that valuations remain at historic highs, the number of quality deals to choose from is limited which is intensifying an already highly competitive dynamic between strategic buyers and private equity sponsors.

“There’s a strange paradox in the market right now - the market is on fire but with a high degree of caution,” said Michael Terwilliger, global portfolio manager at Resource America. “Everyone is crowding the ‘safe’ credits but reluctant to take on much risk.”

With corporate buyers bidding up purchase prices to buy growth and banks hamstrung by leveraged lending guidance, implemented in 2013 and designed to limit the amount of debt banks can extend to so-called junk-rated borrowers, private equity sponsors are caught in the middle.

“There’s a cap on the amount of leverage that sponsors can arrange,” said a leveraged finance banker of the current market.

The average leverage on a buyout in 2Q16 was 5.8 times total debt to Ebitda. In contrast, during the 2007 buyout boom private equity firms piled on an average of 6.8 times total debt.

The higher price tags without the ability to obtain as much leverage means private equity shops are being forced to pony up the difference in order to win a highly coveted business leading, in part, to bigger equity checks.

In some cases, sponsors simply opt to use more equity to finance a deal depending on the investment profile of the target company.

“There are some sponsors that by nature like to put more equity in a deal. Depending on the growth profile and the future financing needs, it makes more sense not to saddle a company with a lot of debt upfront,” Swan said.


For the right company, private equity sponsors seem willing to go the extra mile and pay the full price in equity if need be. In May, Vista agreed to buy Marketo without a financing condition, according to regulatory filings. This is rare, but shows a sponsor willing to pay the full price in equity if necessary.

In February, Apollo Global Management agreed to buy Apollo Education Group for US$1.1bn without a financing condition, too.

Marketo said in an August 16 filing that Golub Capital provided a US$25m revolving credit facility and a US$375m term loan. Marketo did not arrange any junior debt, a source familiar with the deal said.

The five-year senior loans both priced at 950bp over Libor, a hefty price compared to the 2Q16 average spread of 479bp over Libor for first-lien debt.

Vista has previously bought companies without a financing condition, including the September 2014 US$4.3bn acquisition of Tibco Software. However, one big difference with Tibco is that at the time the deal was announced JP Morgan and Jefferies agreed to provide debt commitments, with the company sealing a US$1.67bn term loan to finance the deal. In the case of Marketo, Vista did not get banks to agree to provide financing commitments.

Given that Marketo’s Ebitda over the last 12 months was negative US$49.6m, the deal was likely a hard sell, contributing to the sponsor going to an arranger like Golub instead of trying to broadly syndicated a deal, an investor said. Marketo’s revenue though grew at a rate of 35.4% over the last 12 months, Thomson Reuters data shows.

The firm could probably have arranged junior debt, but it would have come at an even greater cost than the 950bp spread the senior debt carried and mezzanine debt would likely have included warrants.

“Maybe Vista rationalized it was better to write a big equity check than potentially give up some ownership to a mezzanine underwriter,” Terwilliger said.

Golub declined comment. Vista did not return request for comment. (Reporting by Jonathan Schwarzberg and Leela Parker Deo; Editing by Michelle Sierra and Chris Mangham)