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Monday 12th September 2005
Private equity: Balancing the debt
Equity or debt? For the leaders of many growing businesses desperate for expansion capital this is the key question. Yet debt and equity are not as mutually exclusive as often perceived. Indeed, in many respects the debt markets often drive trends in private equity investment.
‘We try to include debt in a lot of our deals as it enables us to gear our investments,’ articulates Peter Hodson, investment manager at venture capital business NVM. ‘Basically it enables us to put less [of our own money] in and therefore we gain better returns.’
However, for a venture capitalist or private equity house, piling debt into transactions is not without risk. ‘The downside,’ Hodson continues, ‘is that the more debt we put in the riskier it becomes for us. If a bank’s covenants aren’t met then suddenly they gain a lot of control over the business and we’re in trouble. Balance is the key.’
Needless to say this balance depends largely on the object of investment. ‘You tend to put debt in when a business has cash flows and can service debt and manage repayments,’ reasons Duke Street Capital’s Marco Herbst, ‘so debt isn’t used much with early-stage ventures.’ Instead, the buyout market tends to be the real sweet spot for these leveraged transactions.
So how much debt is usual?
In the UK the balance tends to be relatively even. ‘Typically, debt would be about 55 per cent of the transaction value,’ Lloyds TSB’s Peter Bate affirms, ‘with the venture capital or private equity firm providing the remainder.’ This is in stark contrast to the US where the banks may contribute upwards of 75 per cent of total deal value.
The exact amount a bank is actually willing to advance is largely dependent on how cash generative the firm being supported is. ‘As a rule,’ continues Bate, ‘we’ll agree to provide between four and five times the earnings of the business in question, though it all depends on the size of the deal going through. We’ll hold between £30 million and £40 million, above that we would look to underwrite the investment and syndicate it out.’
The current market
Despite these limitations the debt market remains strong at present. ‘The banks have been quite aggressive in terms of lending money over the last 12 months,’ says Duke Street’s Herbst. ‘In fact they have been the most aggressive we’ve seen in some time.’
This aggression has manifested itself in a sharp increase in UK buyout activity over the past 18 months. But, warns Jeremy Furniss, a partner at corporate finance boutique Livingstone Guarantee, things could be about to change.
‘In the UK, the banks are quite willing to lay out a lot of debt at the moment,’ Furniss begins, ‘however, there is now some nervousness that the next six months may see the debt market decide it has over-extended itself and pull back. That would leave a bit of a vacuum in the private equity market too.
‘The only saving grace is that while the big debt providers like HBOS may slow down, there are plenty of young turks – including Bank of Ireland – who are looking to establish themselves.’
Elliott Davis
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