Over Leveraged Private Equity Investments

I’m not talking about us, private equiteers (although that argument probably has merit too), I’m talking about our investees. We were leveraging them to 2-4x EBITDA (in mid-market deals) but today’s EBITDA isn’t yesterday’s EBITDA and hence the multiple may not be 2-4x anymore. On top of that, we leveraged to the point where covenants were tight and now, well, let’s just say they’re not tight anymore because they’ve been smacked out of the park. Okay, maybe that’s an exaggeration, my firm’s covenants are borderline, as long as borderline means safely into breaching territory (see insert of orca breaching).

So going through a similar example from a previous post, consider a business that is doing sales of $100m, has a gross margin of 60%, EBITDA of $20m, debt of 4x EBITDA ($80m) and interest payments of 7% ($5.6m). Let’s say sales drop 20%, so there’s an instant loss of gross profit of $12m. So EBITDA is now $8m and you still have interest payments of $5.6m. On the positive side, you still have the paper earnings to potentially pay your interest. On the downside, your debt is now 10x EBITDA (Over leveraged!), your EBITDA is less than 2x interest payments (over leveraged!), and you can almost be certain your FCF won’t cover principal and interest payments (over leveraged!). You know what they say about three strikes…?

I don’t mean to sound like a killjoy, but this is the landscape of private equity now. This even goes for the mid-market managers that have lamented high leverage ratios and are self-professed conservatives. A drop in sales from an economic downturn can have serious consequences and that’s before thinking about debt covenants. Throw a covenant or two into the mix and the result isn’t pretty. Here’s hoping for more sales and fewer whales (the breaching variety).

Over Leveraged Private Equity Investments