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Private equity wrangles with costly debt

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Illustration: Annelise Capossela/Axios

Private equity will continue rolling equity and partnering with other sponsors to mitigate costly debt and narrow valuation gaps, dealmakers tell Axios.

Why it matters: Rockier dealmaking conditions could continue this year, given imminent interest rate cuts are likely off the table and the timing of their eventual arrival is uncertain.

Flashback: "Last year you couldn't get the leverage package you wanted," says one middle market private equity investor.

  • "Now I think you can get it but it's a matter of what you want to pay for it," he says, noting "debt is more expensive than it's been for most of the last two decades."
  • In 2023, LBO equity checks topped 50% for the first time ever as PE firms struggled to afford as much financing as years past.

The big picture: "Given the movement in base rates, the primary constraint on leverage is fixed-charge coverage," says Court Square co-head of health care David Nguyen.

  • "Even in higher-multiple transactions where loan-to-value is below 50%, aside from a few sectors, we still see reluctance from lenders to stretch to 6x leverage," Nguyen says.
  • Lenders are increasingly focused on the quality of leverageable EBITDA (i.e., quantity of adjustments) — particularly with multi-site rollups, Nguyen adds.

Between the lines: Sponsors facing steep haircuts in exiting investments are now wondering, "Can I get a deal done? And is my company ... good enough?" says the middle market MP.

  • "And so maybe this is why I think we are seeing these kind of 50/50 deals, to give capital back to LPs," he adds. "Even though I'm not crazy about the price, but it's good enough right now."

Sponsors are also rolling portions of their investments to capture future upside,"

  • "However, in doing so, the sponsor is ceding the timing of a full exit to the new buyer, which in turn can extend the life of the selling fund," the middle market MP says.
  • It's an imperfect solution, but one that may be preferred by LPs to a continuation vehicle.

The bottom line: "GPs still must manage the conflict that arises when a subsequent fund is investing in an asset being sold by a prior fund," says the MD.

  • "A truly competitive auction process where a third party is setting price and terms accomplishes that."

Editor's note: This story has been corrected to reflect the attribution for the quote about leverage constraints is from Court Square co-head of health care David Nguyen.

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