- Capital Call by OneFund
- Posts
- Private Equity’s Increasing Use of Equity to Fuel Add-on Growth
Private Equity’s Increasing Use of Equity to Fuel Add-on Growth
Capital Call - a bi-weekly newsletter from LPs for LPs, covering the latest and greatest from across the private markets
Calling all LPs! Thanks for joining me (John Bailey, Co-Founder at OneFund) for another edition of Capital Call. A bi-weekly private equity newsletter from LPs for LPs.
The mission of Capital Call is to deliver concise, top-notch insights and updates from the private markets tailored to what matters for LPs.
This week we will be looking at:
Industry Insights: Private Equity’s Increasing Use of Equity to Fuel Add-on Growth
Fundraising updates and VC/PE reports
GP Perspectives from Ray Dalio & Scott Lader
About OneFund
OneFund is democratizing access to Private Equity and Venture Capital for everyday investors. We partner with the world's top PE & VC funds to offer investment options without the million-dollar minimums.
If you would like to follow what we are doing, get more regular updates directly from the team, or become a member, schedule a call!
Industry Insights
2023’s lending landscape has continued to prove difficult for sponsors, with rising interest rates, risk-averse lenders, and concerns about increasing debt costs. However, the historic $3.7 billion in private equity dry powder in the market, as estimated by Bain, means GPs have considerable pressure and opportunities to strategically deploy capital.
As a result, the add-on strategy has gained significant traction over the past few years, now comprising 78% of deals in the first half of 2023, according to Pitchbook’s research (as seen above). This is in part due to its structuring ease and valuable synergies for organic growth potential. But now add-ons, previously highly levered, are being funded with more equity than ever.
A typical 8x EBITDA add-on transaction would previously see its sources include 1.5-2x turns of EBITDA in equity and the rest funded with leverage. Sometimes these deals could even be fueled by no equity at all. Compare that to 1H 2023 where those same types of deals are often being funded with up to 4-5x equity. This follows trends within the broader syndicated loan market, where the average debt to EBITDA ratio for loans issued in Q1 2023 stood at 4.7x, lower than the 5.3x figure recorded in 2021. In this week’s capital call, I’ll dive into the impacts of private market capital structure trends and the consequences most important to LPs.
Sacrificing Near-Term Returns for Flexibility
Any substantial reduction in add-on leverage will reduce IRRs underwritten in the near-term, but it also serves as a tool for managers to reduce their cash flow risk on an investment. Deleveraging platforms generally provides greater flexibility to deal with any economic uncertainty a fund manager may be predicting.
Sponsors pursuing add-ons must be aware of “most favored nation” (MFN) provisions, where existing credit lenders to a company have the right to reprice debt when they see incremental new debt receiving higher interest rate margins. These provisions are common in the middle market and can mean a small add-on acquisition using debt can raise interest costs through an entire debt facility stack. Sponsors must evaluate the cost of new debt and whether it will impact the cost of existing debt during legal due diligence.
How Should LPs Think Through This?
LPs that see their GPs underwrite add-ons at lower IRR returns due to less leverage should not be alarmed as long as the add-ons have strong fundamental rationale. Sponsors are willing to put more equity in the short term on deals that have a strategic fit or provide significant synergies within their platforms. They can then readjust the capital structure once debt markets loosen and revise return expectations upwards. Given add-ons may remain dominant in private equity buyouts for the near future, LPs should ensure their GPs are able to execute a strong add-on strategy that positions them for further upside once market conditions improve.
Add-on strategies are not easy to execute, however, and typically rely on experienced, high performing GPs. Post-merger company integrations are no joke. For LPs, here are three qualities Bain highlights to distinguish capable sponsors:
Deep, holistic diligence is critical: Add-on strategies begin before the first acquisition. Effective sponsors deeply understand value creation using a specific platform and have well-defined add-on targets. They can easily answer questions such as: Are there enough targets in the sector, and is it stable enough to support growth? Does the platform already have the right infrastructure to make acquisitions, or will you need to build those capabilities? Who are the potential targets, and what do they add?
Execution is as important as the investment: GP leadership teams should be ready to execute immediately after acquisition and realize near-term synergies such as IT systems and employee integration. There are different models that can work, including reliance on the deal team or a fully dedicated platform team, but specific synergy components must be executed by dedicated staff.
Pattern recognition counts: GPs with extensive add-on experience have an edge. However, they must make a conscious effort to diagnose what worked well or didn’t with past deals. This analysis should include choice of targets, and how decisions along each phase of the investment value chain added or destroyed value.
Updates from Across the Ecosystem
Fundraising
Reports
GP Perspectives
Reacting to the recent 0.25% rate hikes to up to a 22-year record of 5.5%, Ray Dalio notices the economy is reacting much stronger than expected. This is because recent monetary policy in the past few years has shifted wealth from the government’s balance sheet to the household sector. Governments and central banks have poor balance sheets due to the vast debt they raised, but this wealth was transferred to households. As a result, the strong private sector hasn’t reacted very sensitively to the Fed’s rapid rate hikes. In recent years, the private sector’s net worth rose to high levels, unemployment rates fell, and compensation increased, giving a buffer to resist the cooling economy seen in 2022 and 2023.
Looking forward, Dalio predicts a period of tolerably slow growth and tolerably high inflation (mild stagflation). He believes it is virtually certain that governments’ deficits will remain large, and that they will grow at an increasing rate as the increasing debt service costs and other budget costs compound upward. As a result, central banks will be forced to continue printing more money and buy more debt as they experience losses and deteriorating balance sheets, forcing long-term inflation at above historical levels.
Horizon Investment’s CIO, Scott Lader, states we’ve likely seen the peak in rates and the lows in multiples. Lader is doubtful of the rumors of an additional Fed rate hike due to continued strong disinflationary data in the U.S. that reduces the Fed’s incentive to do so. Based on macroeconomic indicators, Horizon Investments states there will not be a recession within the next twelve months. Another interesting insight from Lader believes consumer staples and other defensive industry companies are overvalued due to their elevated multiples from “perceived safety” as well as the recent calming inflation reducing their pricing power.
About OneFund
OneFund is democratizing access to Private Equity and Venture Capital for everyday investors. We partner with the world's top PE & VC funds to offer investment options without the million-dollar minimums.
If you would like to follow what we are doing, get more regular updates directly from the team, or become a member, schedule a call!
Reply