(Reuters) – Big private equity deals have fallen through or had to be reworked in recent weeks because many banks, under U.S. regulatory pressure to reduce their risk-taking, are no longer willing to provide as much debt as their clients want.
This could lead to lower returns for private equity investors, because they are being asked to put more of their own money into deals, potentially reducing their return on equity. Reuters interviews with several private equity executives and investment bankers, who asked not to be identified disclosing confidential information, show that buyout firms now regularly project annualized returns of about 15 percent when they agree to deals, even as they promise 20 percent-plus returns to investors.
Last month, a potential $7 billion acquisition of Canadian satellite company Telesat Holdings Inc by Ontario Teachers’ Pension Plan and Public Sector Pension Investment Board was scuppered by financing issues, according to people familiar with the matter.
A consortium of banks, led by JPMorgan Chase & Co, had offered to finance the deal for Telesat’s parent, New York-based Loral Space & Communications Inc, offering much more debt than regulators are comfortable with, the sources said.
After discussions with regulators, however, JPMorgan revised its debt financing offer down, offering to lend an amount equal to closer to six times a measure of Telesat’s cash flow known as earnings before interest, tax, depreciation, and amortization (EBITDA). A JPMorgan spokeswoman declined to comment. In 2013, the Federal Reserve and other U.S. regulators set six times EBITDA as a guideline for the maximum debt they see as reasonable in most deals.
For two years, banks tested that guideline, and although they were reprimanded in letters for exceeding it, they were willing to accept a slap on the wrist. Now, most regulated banks are no longer willing to go much above the guideline, industry sources said.
Data is beginning to bear this out-average levels of debt relative to EBITDA, or leverage, have dropped to 6.3 times so far in 2015, versus a 6.6 percent average in 2014, according to Thomson Reuters Loan Pricing Corp. Industry sources expect it to drop further.
“We are at a point that (the guidance) is actually having an impact,” Joshua Lutzker, a managing director at buyout firm Berkshire Partners LLC, told the Harvard Business School Venture Capital and Private Equity Conference earlier this month. “There are a number of deals that did not get done or that have restructured.”
The Telesat deal is not the only one that has been affected by debt limits.
Last month, apparel retailer Express Inc, which has a market capitalization of $1.2 billion, said it ended talks to be bought by private equity firm Sycamore Partners because of unavailability of financing on commercially acceptable terms.
Sycamore is now in talks to acquire another apparel retailer, Chico’s FAS Inc, for about $3 billion, but securing attractive debt financing is also a big hurdle in that deal, sources said this week.
Big deals that do scrape through are seeing their leverage levels lowered. The financing for the $8.7 billion acquisition of Petsmart Inc by a private equity consortium led by BC Partners Ltd that was agreed in December had to be reworked so that only $6.2 billion of the $8.7 billion buyout is financed with debt, resulting in adjusted leverage of about 6.2 times EBITDA on a pro forma basis based on 2014 third-quarter earnings, according to Standard & Poor’s Ratings Services. Several major banks still ended up passing on that deal on regulatory concerns. [ID: nL1N0VL2GO]
A BIT OF SANITY
Regulators are looking to ensure that the cheap money that the Federal Reserve has flooded financial markets with since the 2008 financial crisis does not result in a bubble for leveraged buyouts. Some private equity executives welcome this tightening in lending standards.
“If that really aggressive leverage package is available, it really takes only one buyer to use it, to come in aggressively and top everybody by paying more for a business that is probably not worth it,” Jay Sammons, a Carlyle Group LP managing director, told the Harvard conference. “The bright side of (the guidance) is that it puts a little bit of sanity back into the competitive landscape.”
All private equity firms, however, stand to feel the pinch from the leveraged lending guidance when they try to sell companies they have already acquired to other private equity firms. Lower leverage makes an auction for a company less frothy, potentially reducing the price of any acquisition offers.
The guidance is also weighing the most on deals valued at more than $2 billion. This is because smaller deals can be funded to a much larger extent from non-banking sources of capital, such as alternatives asset managers, business development companies and non-regulated shadow banks such as Jefferies LLC.
“The impact of these rules has really been on the larger deals where it has always been the traditional regulated Wall Street banks that are making these loan commitments, and, frankly, there is not as broad as an alternative lending market to replace them,” Douglas Ryder, a partner with law firm Kirkland & Ellis LLP, told the Harvard conference.