InSight

Exit and Growth Strategies for Middle Market Businesses

Private Equity Seeking Smaller Deals

By Kim Levin | May 05, 2015

Money GraphRecent articles in both the Wall Street Journal and Reuters shine the spotlight on the conundrum facing Private Equity firms working under stricter regulatory guidelines designed to curb dangerous lending practices.  On one hand, it is understandable and prudent to expect policies to be in place to prevent the kind of financial melt-down we experienced during the recent sub-prime mortgage fiasco.  On the other hand, Private Equity firms have traditionally used substantial leverage to their advantage, boosting returns on investments for their portfolios and their investors.  Current regulatory guidelines urge banks to avoid putting debt of more than six times earnings before interest, taxes, depreciation and amortization, or EBITDA, on companies in most industries.

As major buyers of businesses, both public and private, private equity firms use a combination of cash and debt to finance their purchases.  The higher the level of debt, the greater the potential return when things go as planned.  However, when expectations fall short…use of leverage compounds the shortcomings.  We have begun to see both buyouts and loan levels dropping.  According to the Wall Street Journal article “Buyout Firms Feel Pinch From Lending Crackdown”, bankers and private-equity executives indicate the lending pullback is creating pressure on buyout firms to do smaller deals funded with less debt and more cash.  Less debt can mean less risk if the deal goes south, but also lower returns if it proves a success.

The fact that private equity will be seeking out smaller size deals plays into the hand of  middle-market business owners considering a sale.  Average debt levels on middle market deals have stayed within the regulatory guidelines since they went into effect in 2013, according to GF Data.  It is likely this trend will continue for middle-market transactions.

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