Adding Insull to Penury: Samuel Insull was the early model for what has become the modern private equity industry. A British-born entrepreneur, he served for a few years as secretary to Thomas Edison. By 1915, he set out on his own to build a utility empire. He eventually owned 65 companies operating in 32 states with assets over $4.0 Billion, supported by only $27 MM of equity capital built through a series of leveraged buildouts. He was the Elon Musk of his era in both his brashness and his evangelical belief in electricity, as he brought electric service to more American homes than any person in the nation’s history. Unfortunately, during the 1920’s, he was one of the many who believed the good years would never end and he continued to finance his business with growing leverage. His empire was ruined by its debts in the early 1930’s. He died personally owing $15 MM to various creditors with only $1,000 to his name.
The four-plus decade history of modern private equity is riddled with creative, sometimes stunningly risky, attempts to propel rates of return and to use increasing amounts (and increasing multiples) of OPM (other people’s money). Early 1980’s buyouts were presented to lenders by emphasizing EBIT and its worthiness as a credit North star. Lenders agreed to lend 3-4x EBIT over a several-year period but no more. Since the multiple was a constant, the private equity world decided to move the multiplicand. Duh? – No DA. They altered the credit requests to focus instead on EBITDA which was always higher than EBIT and often substantially higher. If one could convince a lender to multiply EBITDA, instead of EBIT, and then adjust for capital expenditures, leverage was again increased.
The early 1990’s arrived like a lamb as recession and the first Gulf War dominated economic concerns. The U.S. banks were so jaded by the credit fallout of the late 1980’s and by the Drexel Burnham collapse that in the early 1990’s, that tiny Creditanstalt of Austria became a leading U.S. middle market lender. Once the Gulf War ended, one of those major psychological switches was pulled and lenders appeared with great enthusiasm accompanied by a new, well-capitalized competitor in GECC, which was bound by neither traditional banking practices nor regulations, and led the way on increasing leverage multiples. Investment bankers, not ones to be caught napping, sensed an opportunity to again increase the multiplicand now that the leverage multiple was rising. Bankers gave birth to the addback, the financial equivalent of the guy on the barstool recalling his youthful fitness. Addbacks were a list of “bad” economic events that cost a business money they would like the prospective buyer to ignore. If a long list of addbacks were thrown against a financing wall and some of it stuck, the leverage would increase. Addbacks have ranged from the credible, one time legal settlement, to the incredible, bonus payments to management in the unlikely event they would not want any future bonuses.
Once the leverage tree seemed to have reached the sky, private equity sought to push the rate of return envelope, even though they and their investors would earn less money, by adding a layer of leverage at the investment Fund level. The era of the credit line emerged in the late 1990’s. Banks extended credit lines to Funds to permit deferrals of capital calls from a Fund’s investors. The net math resulted in higher rates of return at the Fund level as equity capital was funded later, but less cash profit was earned due to the added layer of interest burden. Deferral also increased the risk of a calamitous fund-level event as the delayed equity draw meant the fund had now undertaken the risk of failing investors, (see 2000 – 2001) post a deal closing, which could cause a fund to default on a credit line repayment and ignite a default chain rolling through a Fund’s portfolio.
The use of credit lines has become ensconced in private equity practice today despite the rapid rise in interest rates over the past two years. At the beginning of Covid, many Funds had 25-35% of their capital commitments on their credit line. When Covid hit, fears of the 2009 financial collapse repeating itself gave rise to panicked general partners rushing to call capital to pay down the lines in case limited partners defaulted and as they watched portfolio companies shut due to Covid restrictions. Nevertheless, the habits that paved the way to that panic were quickly resumed as lenders and the Fed eased credit.
The high leverage/purchase multiples and low interest rates of 2018 – 2021 led to a frenzy of higher priced acquisitions in private equity as many acted as if perpetual liquidity were assumed to be constant. However, multiple Fed rate increases dramatically slowed the pace of mergers and acquisitions and shut down the IPO market. The Fund investors who had bought the perpetual liquidity theory were scrambling for cash. Quite naturally, private equity sought yet more leverage as the cure to investors’ worries about liquidity. The form of this new leverage is the NAV loan which essentially is a debt instrument collateralized by a Fund’s existing investment portfolio, contrasted to a Fund credit line which is collateralized by uncalled investor capital. The principal uses of the NAV loans are to pay a distribution to investors or to invest more money in a portfolio company that is in distress and cannot access third-party financing. Current rates for NAV loans are 11 -13 %. Let’s analyze this for a moment: were the loan proceeds distributed to investors, they would receive possibly recallable cash, which they can invest at 5%, and which they are renting for 13%. Even if not recallable, is this arbitrage sensible? If the money is instead placed in a struggling portfolio company several other issues arise: 1) pricing the new junior risk capital if one of the parties besides the Fund might benefit; 2) the additional risk being taken by now wagering your better horses to support your lame one has tobe examined; and 3) is the company likely to survive under an even greater debt burden? Continuing to double down on a bet is the triumph of hope over management as Samuel Insull demonstrated.
I’m Rob Morris and I approved this blog.