Breakingviews - Private equity growth fetish stores up future pain

A man speaks on his phone as he walks past The Gherkin and other office buildings in the City of London, Britain November 13, 2018.

LONDON (Reuters Breakingviews) - Buyout barons may no longer be the rapacious cost-cutters of popular imagination. According to consultancy Bain & Co’s annual private equity study, released on Monday, the industry is pinning its hopes on boosting revenue to justify rich valuations. The cuddlier image risks lower returns.

Private equity titans like Blackstone’s Steve Schwarzman and KKR’s Henry Kravis spent $592 billion in 2020, or 7% more than the five-year annual average. Valuations also defied the pandemic. The average deal in the United States was done at a near-record 11.4 times enterprise value to EBITDA multiple, while Europe’s 12.6 times was the highest ever. Since 65% of deals were in sectors that are resilient to lockdowns, like technology, it’s unlikely that the high multiples reflect falling EBITDA from the crisis.

How can Schwarzman and co make money with prices so high? The answer, increasingly, is growth. Bain’s analysis found that private equity returns are now predominantly driven by boosting revenue and selling companies at a richer valuation than when they are bought. Since the latter tactic, known as multiple expansion, is unlikely to work with today’s high purchase prices, the onus is on increasing sales.

The shift away from cost-cutting makes sense. The proportion of secondary buyouts, or those companies which have already been through the private equity wringer, is rising, meaning less fat to cut. And public companies, with the help of activists, keep a tighter leash on expenses.

Yet relying on growth makes it harder to justify high prices. A buyout firm that acquires a company for 12.6 times EBITDA, and sells it five years later at the same multiple without improving profitability, would need revenue to grow by 8% a year to hit the 20% internal rate of return that private equity groups typically target. That’s according to Breakingviews calculations that assume leverage of 7 times EBITDA, with annual interest costs of 5%.

Few companies consistently increase their revenue that fast. The median annual growth forecast over the next three years for firms in the FTSE 100 and S&P 500 indexes is just 5.6%, Refinitiv data shows. Less than one-third of the group will surpass 8%. Meanwhile buyout funds have roughly $1 trillion of cash to spend, Bain reckons, meaning more capital is chasing a dwindling number of targets. Private equity’s growth fetish risks shrinking returns.


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