Private equity firms are under increasing pressure to use more equity to finance their add-on acquisitions because of concerns that taking on more leverage will increase the cost of existing debt on their platform investments.
When interest rates were low and lending standards were relatively loose, PE firms enjoyed a lot of flexibility in funding add-ons. Companies and their PE owners would typically tap an existing credit facility—either a revolving facility or a delayed draw term loan—or layer incremental debt onto current liabilities. Because debt can help maximize returns on acquisitions, using cash on hand was often a last resort.
But rising interest rates, risk-averse lenders and, in some cases, existing covenants are restricting the amount of debt that buyers can tap.
This poses challenges for PE managers hoping to clinch deals, even for add-ons, which have made up a bigger share of PE activity as investors put off platform acquisitions that require more debt financing—accounting for 78% of total US buyouts in H1 2023.
In the first six months of the year, there were only 1,827 add-ons, a relatively small number when compared with 2021 and 2022’s full-year tallies of 5,681 and 5,312, respectively.
It has become less common to see add-ons fully funded with borrowed money. They are often structured with a variety of financing methods that can include cash on the acquirer’s balance sheet, additional equity issued by the PE owner and its co-investors, or a combination of debt and equity, said David Hayes, a partner at law firm Reed Smith.
Some PE managers don’t tap as much debt as is available, choosing instead to inject more equity into add-ons so that they can rein in leverage of platform companies and help them stay compliant with credit covenants.
By putting in more equity, they hope to create a combined business that has a more manageable capital structure that has some breathing room to deal with the economic uncertainty down the road, said Nitin Gupta, a managing partner at Flexstone Partners.
In the past, if a PE firm pursued an add-on with the purchase price of 6x to 8x over EBITDA, they may have taken 6x to 6.5x of leverage and put in 1.5x to 2x of equity, or possibly no equity at all. Now, firms will do that same deal with 3x to 4x of leverage and the rest in equity, Gupta said.
“Private equity funds are OK putting in more equity in the short term on deals that they really like or see a lot of value in synergies,” Gupta said. “When the bank debt market opens up again, they will readjust the capital structure and take some money back.”
An important hindrance to acquirers’ willingness to tack on additional debt is the concern of triggering “most favored nation” provisions, or MFN.
Many credit facilities in the middle market contain such clauses, which grant lenders the right to reprice existing debt when they see new loans receiving higher interest margins than old ones.
Given the recent rise in interest rates, if a company tacks on even a small portion of incremental debt for an add-on, its existing lenders could force the amendment and jack up interest costs of the entire debt facility, said Justin Wagstaff, a partner at law firm White & Case.
“For existing deals, you have to evaluate what the cost is of the new debt and whether it will impact the cost of any of your existing debt when you’re incurring new debt,” Wagstaff said.
Meanwhile, lenders who support buyout financing have been tightening their grip on borrowers, leaving less room for additional debt. In the broadly syndicated loan market, the average debt to EBITDA ratio for loans issued in Q1 2023 stood at 4.7x, lower than the peak of 5.3x recorded in 2021, according to data from PitchBook LCD. This suggests banks and other investors in the leveraged loan market are becoming more conservative with how much they are willing to lend.
Private credit lenders are also shying away from highly levered deals, according to Hayes, who said he hasn’t seen many transactions with a total leverage multiple of over 5x.
Related read: PE turns to add-ons with large LBOs out of reach
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