DEBT:

PRIVATE EQUITY HEAVEN

OR HELL

CEO – CONSULTATIVE FORUM

IESE BARCELONA MARCH 2011

Antonie Paul Woodbury

Introduction

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

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Debt

John Maynard Keynes

“If I owe you a pound,

I have a problem; but if

I owe you a million, the

problem is yours.”

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Debt

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

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What debt does PE use

„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”

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Debt

O = Overleverage

The natural state of big PE fund portfolio companies.

Recently countries too

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An easy way of thinking about it …7

And the bank‟s model changed

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

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Securatisation9

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

Reasons for securatisation‟s10

Availability of

funds

Liquidity

Diversification

(reduces

unsystematic

risk)Note: US market only data

EU securatisation‟s (end 2007)11

And for those who “guaranteed”..

The “quality” of the

securatised debt

product was also

often enhanced

Monolines insurers

– in the US others

e.g. Lehman, AIG,

Fannie Mae

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Private Equity view

Generally debt is cheaper than equity

Debt is good –particularly if it increases the expected (or hurdle) return on equity

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Cost of Capital

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)

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What drives PE - targets

Hurdle – Return target

of fund net of costs

typically IRR 15-20%

Above that PE Fund

(partners) earns

carried interest

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Private Equity returns

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'.

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PE 2008 loan default predication

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

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Significant debt repayment

Clear signs

of debt

reduction in

2009.

Source: SVG Jan 2011

(from sample of large

PE owned companies)

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Reduction in debt (non weighted average year on year change)

Variable but

declined

significantly

in 2009.

Source: SVG Advisers

Jan 2011 (from sample

of PE owned

companies)

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Significant deleveraging

Key ratio of

Net Debt to

EBITDA has

changed

from 6.3 –

4.7

Sources: Preqin 4th

Qtr 2010

SVG Advisers Jan

2011

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Debt maturities extended

Clear signs of debt reduction in 2009

Source: SVG Advisers Jan 2011 (from a relatively sample of PE owned companies)

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The maturity cliff

Twin trends:

Declining bank

lending

Reduced derivative

market liquidity

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So is the ambulance still needed?23

High Yield takeouts – one answer

Other reasons it wasn‟t as bad ..

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

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Also matters because:

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

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Summary

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!

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Summary cont …

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

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Not as simple as Heaven or Hell

What have we learnt?

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Antonie Paul Woodbury March 2011 apwoodbury@gmail.com

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