I wonder how many private equity leveraged buy-out deals between 2005 and 2007 had $US130 per barrel oil in their five-year business models? How about none?
And how many EBITDA (cash flow) to debt ratios were set with a 2008-09 recession in mind? Also none.
Not that a recession is a prospect here, but with petrol well above $1.50 a litre, standard variable mortgage rates approaching 9.5% and house prices tipping over, the Australian economy is about to be crunched.
So far the corporate distress has been confined to a few highly leveraged players that needed to re-finance debts and could not, such as Centro, and margin lenders caught when the sharemarket tanked, such as Opes Prime and Lift.
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The market rally since mid-March has taken the pressure off the leveraged equity traders and their providers, while Centro has won an extension on its $2.75 billion in debts until 15 December.
The next wave of distress will break when shrinking EBITDAs – earnings before interest, tax, depreciation and amortisation – start putting private equity deals in breach of the loan covenants regarding cash flow cover of interest payments.
Industrial earnings in Australia look about as vulnerable as resources earnings look robust. Since the start of February the ASX industrials index has fallen 15% while the materials index has gone up 7% and the energy index has soared 30%.
The equity market is clearly anticipating problems for industrial companies, but not all of them are funded by equity these days as a result of the private equity boom of 2005-2007.
In most deals, the debt was locked in for up to five years and, unlike with Centro, does not need to be re-financed in the midst of a credit crunch unless covenants are breached.
There was a move last year towards “covenant-lite” deals, in which the covenants are difficult to breach. The Qantas LBO was going to be covenant lite. But not many of these deals were actually done, and they are now as extinct as the Tassie tiger.
There is no public register of EBITDA to interest cover covenants; nor is there public information on the EBITDA covers on which the deals were financed in the first place, or how they are going against forecast and covenants now. That’s one of the main benefits of private equity, of course – it’s private.
However it’s known that last year’s two big media private equity deals, when James Packer and Kerry Stokes sold half of PBL Media and Seven Network to CVC Asia Pacific and Kohlberg Kravis Roberts respectively, registered the high water mark of EBITDA to debt ratio.
Debt was said to be around six times EBITDA for both deals. The timing of both Packer and Stokes was wonderful; CVC and KKR were happy to have bought into stable cash flow businesses that could be safely leveraged.
Yes, but how safe with $1.50 petrol and three official rate increases (plus a few unofficial ones as well) since then? What happens if the debt to EBITDA ratio blows out to 10 times because cash flows decline with the economy?
That’s not to pick on those two deals – there were plenty like them, although they were about the last of the boom and probably they carried the highest debt ratios.
And it’s not just Australia of course: nine of the 10 biggest leveraged buy-outs in world history took place in the past three years, and the later they were the greater the leverage tended to be.
The acquisition of Hospital Corp of America for $US32.7 billion in 2006 by Bain, KKR and Merrill Lynch, included just $US5.5 billion in equity – the rest was debt.
We are now entering white-knuckle time for all of those deals.
This story first appeared in Eureka Report.