The formulas, tricks and trade secrets of Private Equity

Over Gearing Over Paying

Sample Chapter

See this chart of the LPX50 for the past 12 months… wow is all I can muster. The LPX50 is an index of the largest 50 liquid listed private equity funds. The LPX50 is obviously affected by market sentiment and market movements, so to be fair, it’s not the best representation of large unlisted funds. But to be fairer, we’ve seen endowment funds writing down their unlisted private equity investments by similar magnitudes.

The LPX50 has dropped some 60-70% in 12 months. That’s dystopia in anyone’s language. But, I find myself asking why values have dropped so much in such a short period if the world still has a relatively strong pulse. Here are the few off-the-cuff reasons why large funds are having a harder time:

  1. Over Paying: by over paying a high multiple, you’re assuming rapid value creation. When this doesn’t happen, there’s rapid value decimation. A high price also usually means a higher debt/EBITDA multiple.
  2. Over gearing: I’ve seen purchases with a debt/EBITDA multiple of 9x. This implies it would take nine years to pay the debt off… that is, if there were no interest charges. Any minor drop in sales can magnify the issues to the point of instant bankruptcy. This 9x business is now more like 15x as a result of falls in sales.
  3. Media exposure: these funds are contemptuously scrutinised on a minute-by-minute basis by the media. Especially with listed funds, this creates negative sentiment and cliff-like price falls. One could argue that smaller funds would experience the same fate with the same level of media exposure.
  4. Revenue falls: I explained in a previous post the amplifying effects of revenue falls. I’ve even referenced it in a range of other posts because while it’s so fundamental, it’s so easy to forget. Businesses are risky and sales can be volatile. This hasn’t changed, so there should be mitigation and contingency for these falls.

Mega-buyouts enjoyed a period of higher and higher multiples (over paying maybe?) and easier and easier debt up to 2007 (over gearing maybe). But, that’s finished. The fallout from being overly optimistic is much worse than most of us thought it would be (including me). If there’s anything to learn here, it’s that low purchase multiples and low gearing are key to sustainable private equity investing. Also, businesses are always going to be sensitive to falls in sales when they’re even only moderately geared.

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