Private equity firms use debt to finance acquisitions because debt is typically cheaper than equity. During the financial crisis, many predicted high default rates on private equity debt, but actual outcomes were better. Private equity firms significantly reduced debt levels in 2009 through measures like debt exchanges and equity injections. While debt usage is important for returns, the loss of securitization markets reduced the availability of financing, representing an ongoing challenge.

1. DEBT:
PRIVATE EQUITY HEAVEN
OR HELL
CEO – CONSULTATIVE FORUM
IESE BARCELONA MARCH 2011
Antonie Paul Woodbury

2. Introduction
2
 Why is debt important to Private Equity (PE)
 How does PE think about debt
 What happened to PE debt in the financial crisis
 Looking forward

3. Debt
3
John Maynard Keynes
“If I owe you a pound,
I have a problem; but if
I owe you a million, the
problem is yours.”

4. Debt
4
 D = Debt - means of
postponing pain recently very
popular with the European
Government amongst others
 Debt is not bad –
debt you cannot repay is very
bad

5. What debt does PE use
5
 „Traditional‟
secured bank debt
 Junior equity e.g. mezzanine, convertibles
 Tradeable debt e.g. securatised debt instruments
 Related non-recourse debt structures (cash-flow
based) e.g. “OpCo – PropCo model”

6. Debt
6
 O = Overleverage
 The natural state of
big PE fund portfolio
companies.
 Recently countries
too

7. An easy way of thinking about it …
7

8. And the bank‟s model changed
8
 Traditionally banks
operated under an
“originate and hold model”
 2002 - 2007 this changed
to a an “originate and
Distribute model”
 Change probably directly
related to the rise of
securitisation markets

9. Securatisation
9
 Changing un-rated / unlisted debt into tradable
debt by
 combining the debt obligations into a portfolio
(often in tranches) and
 issuing tradable debt instruments secured by the
portfolio

10. Reasons for securatisation‟s
10
 Availability of
funds
 Liquidity
 Diversification
(reduces
unsystematic
risk)
Note: US market only data

11. EU securatisation‟s (end 2007)
11

12. And for those who “guaranteed”..
12
 The “quality” of the
securatised debt
product was also
often enhanced
 Monolines insurers
– in the US others
e.g. Lehman, AIG,
Fannie Mae

13. Private Equity view
13
 Generally debt is
cheaper than equity
 Debt is good –
particularly if it
increases the expected
(or hurdle) return on
equity

14. Cost of Capital
14
 Cost of Capital (CoC) = CoD + CoE
 Cost of Debt (CoD)= (Rf + credit risk rate)(1-T) (i.e.
actual debt cost plus any tax advantage)
 Cost of Equity (CoE) = Risk free rate of return Rf +
Premium expected for risk βs (RM-Rf)

15. What drives PE - targets
15
 Hurdle – Return target
of fund net of costs
typically IRR 15-20%
 Above that PE Fund
(partners) earns
carried interest

16. Private Equity returns
16
C = Carried interest.
The percentage of the profit
on a transaction that goes to
the partners of the PE firm.
Sometimes known as 'carry'
as in 'too much money to
carry'.

17. PE 2008 loan default predication
17
BCG prediction
in 2008 half the
worlds PE
deals would
default - actual
outcome
significantly
better
Sources: Boston
Consulting Group 2008;
Barwon Investment
Partners Sept 2010;
Private Equity Council –
The Performance of
Private Equity - Backed
Companies in the „Great
Depression‟ 2008 - 2009

18. Significant debt repayment
18
Clear signs
of debt
reduction in
2009.
Source: SVG Jan 2011
(from sample of large
PE owned companies)

19. Reduction in debt
(non weighted average year on year change)
19
Variable but
declined
significantly
in 2009.
Source: SVG Advisers
Jan 2011 (from sample
of PE owned
companies)

20. Significant deleveraging
20
Key ratio of
Net Debt to
EBITDA has
changed
from 6.3 –
4.7
Sources: Preqin 4th
Qtr 2010
SVG Advisers Jan
2011

21. Debt maturities extended
21
Clear signs of
debt
reduction in
2009
Source: SVG Advisers
Jan 2011
(from a relatively sample
of PE owned companies)

22. The maturity cliff
22
 Twin trends:
 Declining bank
lending
 Reduced derivative
market liquidity

23. So is the ambulance still needed?
23
High Yield takeouts – one answer

24. Other reasons it wasn‟t as bad ..
24
 Some top of the cycle debt terms were lax “Cov-Lite”
 Low interest rates means locked in low debt costs –
if you are lucky
 Earnings stabilised / recovered (cost reduction &
some top-line growth) – not a consistent experience
 Equity injections, debt exchanges, high cost debt
refi, IPO‟s – have helped shore up balance sheets

25. Also matters because:
25
 Valuations and fundraising require good deals
available and good exits
 Deals done on today‟s 2010 - 11 terms deliver a
base case 12%+ IRR
 If average leverage can be increased from c50% to
c70% the return increases to 15%+ IRR

26. Summary
26
 This cycle so far seems a little different:
 Approach of Governments, Banks and PE to debt issues
different e.g. low interest costs
 relatively high level of dry powder – higher valuations
 Pre-downturn deals likely to surprise on the upside!

27. Summary cont …
27
 The use of Debt has
not been a poison pill
for PE
 The loss of liquidity,
particularly due to the
reduced securatisation
volumes is an issue

28. Not as simple as Heaven or Hell
28
 What have we learnt?

29. 29
Antonie Paul Woodbury March 2011 apwoodbury@gmail.com