Across the globe, both purchase price multiples, as well as leverage levels, continue to surpass previous cycle peaks and the availability of both equity and debt capital should allow this pace to continue for the foreseeable future. Yet, credit fundamentals still exist and can influence the amount of debt the capital markets will support for a transaction.
In the business services sector, leverage remains readily available to support leveraged buy-outs (LBOs). As a general rule of thumb, private equity shops and investment banks could model out leverage for a transaction based off of the enterprise value. Of course, this causes a bit of a chicken or the egg conundrum, but generally speaking, the leverage markets support LBOs allowing for debt to comprise 60-65% of the purchase price.
For deals in the business services space, enterprise values can range anywhere from 5.5x-15x. Therefore, if you used the 60% debt to enterprise value (EV) metric, this would imply that a business which trades for 5.5x should receive 3.5x of leverage, while the business that trades for 15x could receive 9.75x.
Using 9.75x of leverage for a deal is a bit unrealistic as both senior and junior lenders start to become uneasy once leverage crosses the 7x mark. In addition to looking at the absolute leverage number, lenders are now ditching the easy 60-65% debt-to-cap ratio and are instead focusing on true credit fundamentals and accessing the borrower’s free cash flow to right size the credit facility.
Earlier this month, Platinum Equity purchased Document Messaging Technologies (DMT) from Pitney Bowes for $360mm, which according to reports was just below 7x. Like many private equity firms, Platinum Equity used leverage to support the buyout. However, instead of being limited to 60-65% debt-to-cap ratio, the lenders supported Platinum’s buyout of DMT with 70% debt-to-EV. Despite somewhat limited growth prospects, DMT is a stable, mature business that has strong free cash flow which allowed lenders to get comfortable pushing leverage, even with EV being below 7x.
In the other end of the spectrum, Apax Partners purchased Thoughtworks for $785mm last fall, a transaction reported to be just over 15x. Using the old 60-65% debt-to-EV, this would imply 9.75x of leverage would potentially be available to fund the acquisition. Instead Apax put just 4.3x of leverage on the business during the acquisition. In its rating of Thoughtworks’ debt, Moody’s cited (i) customer concentration and (ii) competitive landscape as well as (iii) susceptibility to another recession as factors they considered. In other words, true credit underwriting of Thoughtworks sustainable free cash flow.
We can surmise Platinum and Apax likely have very different views on the use of debt, but we can be certain the debt markets are using more than just enterprise values to size the debt for LBOs. The DMT business Platinum bought may be a better debt story than an equity investment, while the inverse is likely what drove the meager 4.3x leverage support for Apax’s buyout of Thoughtworks.
What is clear is that the debt markets are eager to support LBOs but are now bringing back more credit fundamentals such as free cash flow to structure private equity (PE) led LBOs. The reintroduction of credit fundamentals makes each deal in the middle market more nuanced and requires timely market intelligence to navigate it successfully.
Livingstone’s global Debt Advisory and M&A teams have the necessary volume to anticipate the ever-evolving credit markets and we would welcome the opportunity to work with you on your next capital raise.