In a high priced, highly levered market, what are the strategies and opportunities for private markets investors? We spoke to Maria Boyazny, Founder and CEO of MB Global Partners, to find out more.
What is your view on the current conditions in the private equity market?
The multiples being paid by buyout firms for assets have increased to unprecedented levels, and half of all acquisitions are happening at over 11x EBITDA, per data from Bain & Co. The wider context for this is that we are in the late stages of a record-breaking bull market that has been driven by the most accommodative monetary policy and quantitative easing environments ever orchestrated at a global level. This generated trillions of dollars of liquidity in the markets, which in turn, produced record prices across equity and credit alike. As this excess liquidity gets drained from the system, volatility will return to our portfolios. There has already been evidence of that this year. I think it is very dangerous to pay high multiples for assets at this stage of the cycle.
What does the shift in interest rate policy mean for private equity?
With such high valuations having been paid for assets in the last few years, we are going to see covenants being broken (where transactions are not covenant light) and companies not having enough cash flow to repay and even service their debt. As interest rates move further, they will make a huge difference for the viability of business models. Companies are so levered that those moves make debt service an increasingly larger portion of the free cash flow and place enormous stress on their balance sheets.
We have started to see the market’s recognition of this fact in the debt prices of companies purchased at high multiples which are already experiencing challenges. Their debt is trading significantly below par, and that might still not be attractive enough yet. If their debt is trading below par, what does that tell you about their equity value?
We have passed the top of the credit cycle and are seeing signs of deterioration.
Many deals were done at the best of times when the credit cycle, the economic cycle and interest rates were all favourable. This confluence of confidence-boosting events led to capital structures being created with the idea that cash flow is going to grow sufficiently enough to make those debt loads sustainable. As the cost of debt service rises with steady but unspectacular growth, how are those companies going to grow into their over-levered capital structures? Creditors are already worried about this, which is why we are seeing debt backed by many buyouts trading below par.
One of the unintended consequences of quantitative easing was the demise of Wall Street market making desks. The Dodd-Frank legislation made it difficult for trading desks within the confines of financial institutions to take on balance sheet risk. The risk capital available to broker-dealers to make markets is now a small fraction of pre-crisis levels (see figure below). This does not allow them to provide support to the markets when it is needed most – in times of volatility – and help smooth out price swings as they have done in prior cycles. This means that the bid-ask spreads will be wider than before and little capital will be available to support asset prices.
Source: Federal Bank of New York and SIFMA
Which parts of the capital structure do you feel are particularly vulnerable as a result?
Obviously, the most vulnerable area is the bottom of the capital structure – so equity in these buyouts is a big area of concern. I would not want to be in the sub debt either. The senior part of the capital structure is a better place, but do you want to be a par lender or would you rather be buying these loans once they are trading at discounts?
Switching to private credit, a lot of capital has been put to work at the height of the credit boom. Some acquisition financings are now done in unitranche form, where a creditor would take everything from senior to subordinated debt. I think you will see that market affected as well.
In my view, we have passed the top of the credit cycle and are seeing signs of deterioration. Therefore, only in the best of credits do you want to be a par lender; you do not want to be par lender to questionable, lower-rated issuers. One of the most telling facts about the credit quality is the percentage of covenant-light issuance. Even in 2007, right before the credit crisis, cov-lite issuance was 25.5%; last year it was 78.6%. Both credit quality and credit standards have deteriorated extremely.
So, where do you see opportunity in credit?
I think the big opportunity is going to be in identifying companies that deserve to exist but that are just way over-levered. It is the classic good business but over-levered balance sheet issue. There is an opportunity to take these same companies that have been LBO'd at 10-12x and recreate them at 5-6x EBITDA through the debt markets. I think there is a significant opportunity to play the stressed and distressed side of the equation.
Increased volatility has a habit of shaking out otherwise reluctant sellers. We have bought a number of assets from sellers following a volatility spurt. For example, there were wide bid-ask spreads at the start of 2016. Volatility pushed some previously hesitant sellers to take what was being offered, because they saw what could happen and the dangers of an over-levered market. Volatility is good at affecting the psychology of the sellers and pushing them to reconsider prices they were demanding in the good times.
MB Global Partners is a tactical special situations and opportunistic credit firm that invests across cycles, and I think at this part of the cycle, it is prudent to focus on niche, downside protected, self-liquidating assets that are not beta driven. We also do the work early and create a watch-list to take advantage of the inevitable repricing of the broader corporate credit market.
As an ancient philosopher taught, “from disaster good fortune comes”. We at MB Global make money for our clients in good times and especially when misfortune strikes the markets.
Under the spotlight: Maria Boyazny
Maria Boyazny is the Founder and CEO of MB Global Partners, a New York-based private equity firm focused on credit and special situations investing. MB Global runs capital on behalf of Fortune 100 companies, foundations, pension funds, insurance companies and family offices. Ms. Boyazny has been named as a Top Five most influential woman in alternative investing, among other recognitions. She is the author of several publications, a frequent conference speaker and media commentator for various news outlets.