September 15, 2017

Breakingviews: Private Equity Gets A Double Dip on Debt

by Breakingviews

Cocktail hosts frown on guests who dip half-eaten snacks back in the sauce. Private equity firms don’t worry about such niceties. In Europe, loan terms have got so loose that buyout groups can in some cases load up companies they acquire with debt, and then come back for more – something that was popular before the financial crisis.

Loan investors typically put limits on how much more a company can borrow. They might cap debt at a given multiple of EBITDA, or limit it to a specific amount. These safeguards are being diluted. That makes it more likely the borrower might struggle, and leaves creditors with less if it does.

One trend is for companies to be given leeway in their loan terms to take on more debt later, even if they have maxed out their limits. One kind of such clause, called a “grower”, allows the extra debt to increase in line with a company’s EBITDA, or other measures. Last year the norm was for that extra debt to be around 50 percent of EBITDA or less. This year it’s 100 percent in the majority of cases where an EBITDA grower is used.

As documents become more complex, they can also have surprising effects. One example is a “prepayment amount basket”, which allows a firm to top up debt that it pays back. By cleverly structuring that alongside other clauses like EBITDA multiple caps, borrowers can potentially borrow what they repay twice over.

Its small wonder buyout firms are exploiting such terms, and lenders offering them. Nearly a third of leveraged loan deals in the first half of this year had both an EBITDA grower and a prepayment basket, according to consultancy Debt Explained. Interest rates are low, and central bank bond purchases force investors to take risks. The European Central Bank may throw sand in the wheels: it wants to make it harder for banks to lend over six times a borrower’s EBITDA.

That said, the double-dipping may continue. The United States has had similar rules since 2013. Moody’s reckons loans made in 2016 on average allow borrowers to push their leverage to nearly eight times EBITDA, despite a similar threshold to the one Europe is considering – suggesting it’s harder than it sounds to make buyout firms lay off the sauce.

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