Keeping the powder dry

Dan Davies is a managing director at Frontline Analysts, the author of Lying for Money, and co-author of The Brompton.

Investment bankers tend to be natural optimists for a simple reason; contrarianism and cynicism don’t get deals done. That can be pretty tough at some points in the cycle, like when the bonus pool is down 40 per cent and the redundancies have started.

That’s why, after nine months of deal drought, the phrase “dry powder” has been making frequent appearances in interviews, to support hopes that things will get better in the second half of the year.

It’s not quite clear what image the metaphor is meant to create — presumably the reference is to gunpowder rather than any other kind of powder that might induce brief sensations of optimism in investment bankers. Perhaps the idea is that banking clients are like a crew of pirates, sailing round the Spanish Main and continuing to plunder booty until their cannons run out?

In any case, the “dry powder” thesis is all about private equity and financial sponsors, and it’s based on the acknowledged fact that after record fundraising in 2021 and “slow but healthy” inflows in 2022, that industry has a lot of cash committed but not yet invested.

A banker would never put it this bluntly, but the basis of the “dry powder” thesis is that if PE firms don’t invest this money, they won’t be able to charge fees on it. So at some point they are going to have to do deals, however lousy the economic and market conditions.

This kind of “forced buyers” dynamic between the private equity and investment banking industries worked very well in the wonder years of 2020 and 2021, and the thesis is that nothing has really changed.

Tyranny of the IRR

Except of course, that at least two big things have changed — the interest rate environment and the availability of leveraged buyout debt. Consider for a moment how buyout firms create value (when they do). According to McKinsey you can disaggregate the “Internal Rate of Return” on a deal into four components:

i) The business-as-usual return on capital employed in the target company

ii) Operational improvements implemented by the PE owners

iii) Improvements in the valuation multiple between purchase and sale

iv) Leverage

Stereotypically, private equity gets interested in a deal when reasonably conservative modelling suggests that they can realise an IRR of 20 per cent or higher.

This list of four components could be extended a bit — you might say that changes in the valuation multiple should themselves be disaggregated into general market returns, and multiple expansion as the result of strategic repositioning, investor relations and other things under the control of the owners.

And because of the way the IRR calculation is made, timing also matters; other things equal, a quick exit can be better than a slower one. But as a stylised way of thinking about the parameters that are available to adjust, it’s not bad.

When you look at it this way, it’s not hard to see why PE firms have been sitting on their hands. If the overall market is going down, then your starting blocks have already been moved a few yards back from the line; either you need to wait longer or accept the possibility of a lower exit multiple.

That puts much more weight on realising operational and strategic improvements, something which is difficult and risky at the best of times, and much more so when we might be going into a recession. In general, these kinds of gains are viewed in the industry as the icing on the cake; to go ahead with a deal, PE partners usually want to see a spreadsheet in which the deal washes its face even if there are no improvements and the business is eventually sold for what they paid for it.

Which in turn means that leverage is not so much viewed as a source of value added on the deal — it is a precondition for there being any deal at all. If you buy a company with a mixture of debt and equity, then use the company’s cash flows to pay down the debt, you’ve increased your returns. If that debt is a lot cheaper than the return on capital that the company is actually earning, then the simple fact of being able to use cheap finance is a value creator.

Leverage and its importance

At this point, an investment in a silly toy spreadsheet will pay huge, private equity-style dividends in the form of stylised examples and conjecture. It’s quite easy to build the McKinsey breakdown of value generation into a very small model, assuming a five year investment/realisation cycle and ignoring capex, taxes and anything else that isn’t worth modelling because this is a toy example.

Let’s start by understanding how the deals boom was supported by abundant cheap finance. Back in 2021, LBO loans were available at a spread of 350-450 bps over Euribor (with protection for zero rates). Plug a cost of debt of 4 per cent into the spreadsheet and play around with the Excel IRR command, and you can quickly see that more or less any company with a 12 per cent ROCE will give you a 20 per cent IRR over five years, even if you don’t improve the earnings or the sale multiple.

This isn’t by any means a worst-case scenario — which is the company goes bankrupt and you lose your investment — but it’s got enough conservatism to convince an investment committee that even if the deal turns out to be a disappointment, it’s still clearing the hurdle rate.

You can also see that this is a pretty conservative financing structure with six times interest cover. If you push the debt financing a bit higher, the IRR is even better.

Bear market psychology

How things change. According to market participants (quoted on Twitter, but not to widespread disbelief), mid market deals are being quoted at 750 bps spreads for the lending if they have a half-and-half mix of equity and debt finance.

Given the change in the interest rate environment, that means just under a 12 per cent cost of debt. Let’s plug that into the spreadsheet and see what it looks like:

The first thing to notice is the IRR — it’s now 12 per cent on that deal. That’s quite a way below the target for most private equity funds. The second thing to notice is that there’s not much scope to do anything more with leverage at this level. The interest cover is two times, suggesting that you’re close to the limit of how much debt the target company can stand.

Furthermore, everything is now dependent on that sale valuation holding. Losing a single point from the exit multiple would put the IRR below 8 per cent, which is a common level for investors to set the “hurdle rate” on a fund that has to be achieved before fees are paid.

So basically, doing deals at this moment in time locks in a very material risk of filling up the fund with investments that will severely drag on its performance in an economic scenario that has to be regarded as close to the base case.

In actual recessionary scenarios where the earnings go down and valuations fall the returns could go severely negative. No matter how much dry powder that pirate ship has, it’s not going anywhere fast if the hull is crusted with barnacles.

It’s important to note here that the problem with the “dry powder” thesis is, on this analysis, driven by the pricing of the debt finance as much as its availability. So although JPMorgan is claiming to be “open for business” and the overhang of financing for “hung” deals like Citrix and Twitter is gradually clearing, that doesn’t necessarily change the stylised arithmetic very much.

A more sophisticated version of the dry powder argument is that private lending funds might play more of a role in LBO finance. That might be right, but as long as the market clearing cost of funds is close to the underlying ROCE of target companies, the benefits of leverage are just harder to achieve. As someone said on Twitter, why take equity risk for the same returns that credit is getting?

Why would anybody want to own the equity (and pay 2/20 on it), if the debt pays 12%? https://t.co/jpEpCCV9pF

— Sheep of Wall Street (@Biohazard3737) January 15, 2023

Blue skies over the horizon

So how to get out of this mess? Is there any way of saving the thesis? Well, thinking back to the decomposition of IRR suggests a few possibilities. What happens if spreads on LBO lending come down a bit? Let’s plug a 10 per cent cost of debt into the model and see how much it helps.

The answer seems to be “a bit, but probably not enough”. Even assuming that you can take full advantage of that 200 bps improvement in terms while still cranking the interest cover down to 2 times, you’re still quite a way off the 20 per cent target. And it’s not difficult at all to create scenarios where the IRR goes to 8 per cent or worse.

A more hopeful prospect might be if private equity got a little bit more optimistic about their ability to improve earnings growth (or to simply benefit from positive macro or industry trends). Even with the cost of debt where it is now, if you can take a company earning 12 per cent ROCE and manage that up to 15 per cent over the course of five years of ownership, then the deal looks fine:

This is not a particularly demanding ask from an industry that sells itself to investors on the basis of its ability to generate operational improvements. And it means that some deals will still be done — those where the opportunity is a genuine slam dunk, and those where the PE guys get itchy trigger fingers.

But this is the sort of modelling that investment committees are there to prevent; what we’ve done here is take the central case and start talking about it as if it’s a downside case.

It’s true that fees can’t be charged on dry powder. But private equity firms understand that their biggest intangible asset is their record of generating IRR. They might be willing to endure quite a few lean years in terms of their own P&L — and even to think about cutting their own costs and headcount — rather than take risks with deals that need stretched assumptions to look good.

A better hope might be to look at those entry and exit multiples. All our back-envelope calculations so far have been carried out on the basis that the initial investment was made at a multiple consistent with acquiring the company at book value (that’s the significance of the 8.3x number in the spreadsheet).

In actual fact, although the assumption was made to keep the numbers looking easy, it’s more or less in line with EBITDA multiples in the 2010s, and quite a bit lower than where deals were happening in the last two years.

But it’s not really important because it’s just a finger exercise based on a stereotypical industrial acquisition. The valuation and ROCE assumptions offset each other, so if you want to calibrate the model to the kind of software roll-up deals that were being done in 2020, you can.

If you relax that assumption and say that buyouts might be closed at lower multiples, it makes the whole model a lot more cheerful.

Since you’re paying a discount (in this model) or a smaller premium (in reality) to book value, the return on capital employed by the firm represents a better percentage return on the LBO investment. It might be easier to show this in numbers than describe it in words:

And when the entry price is lower, it’s easier for private market investors to take advantage of one of their primary means of driving value — the ability to decide on the timing of divestments and sell at a better multiple than they bought.

If the deal can be struck at a reduced multiple but exited at a normal one, the market timing return is part of the IRR. Not only that, but since the overall deal size is smaller compared to the earnings generation of the target company, you can push the debt financing out a bit more while maintaining interest cover.

Pretty soon, you are back to delivering boom-time base case IRRs without having to assume any tricky operational improvements.

The paradox of powder

So, the conclusion here appears to be that for the “dry powder” to be used, the most likely scenario would be one in which overall valuations fell (public and private market), creating an environment in which PE firms could continue to generate the IRRs that they want, consistent with the changed interest rate environment.

So the ostensibly bullish thesis of the hopeful investment bankers is dependent on a significant market correction. Short term pain, long term gain. When you put it like that, it’s not too implausible.

Except that . . . one of the things that is stopping prices from falling is the fact that in many cases they are supported by an expectation that there is a valuation floor under the market because of the likelihood of private equity bids for any company that looks cheap. After all, there is so much “dry powder” that has to be put to use etc etc …

So the industry is in a circular bind. Private equity firms can’t do buyouts until valuations fall further, and expectations of private equity buyouts are helping support valuations. The bankers who are relying on dry powder to keep their hopes alive are like doomed characters in mythology; as long as they maintain that hope, nobody else is going to capitulate either.

This equilibrium can persist a long time, and when it breaks, it will break for some exogenous reason, not just because private equity funds are struck with a compulsion to do deals just because they have money to invest.

Like its close cousin, “cash on the sidelines”, dry powder is really just a coping strategy for people who wish things were different to how they are.