Henry Kravis might be wrong

Despite the title, I’m a big fan of KKR co-founder Henry Kravis. He is the Julis Caesar of the Private Equity Superstate.

Having had a few days to reflect on the “we aren’t over-levering our deals” proposition put forward by Mr. Kravis last week in Halifax (as reported here “Henry Kravis on the ‘bubble question’” May 31-07 and “KKR Founder Henry Kravis on PE climate” May 29-07), I’ve got an angle for you to consider.

As I mentioned to the Globe last week, Mr. Kravis didn’t address the question of rising purchase multiples (ie., increased prices for companies) in his compelling speech. This post is meant to delve into why acquisition prices have a crucial impact on the senior lender should the economy ever slow down. Let’s assume one firm was acquired in 1980 and the other in 2007. Each had a steady $200 million of EBITDA (only $25 million of maintenance capex) and the acquisition multiples were 6x EBITDA in 1980 and 9x EBITDA today.

Rule of thumb these days is that 30% of the purchase price is financed with equity and the balance with debt (Scenario A). That compares to the 1980s vintage 13% equity / 87% debt figures (Scenario B) that Mr. Kravis talked about last week (those percentages are the average of the five examples he used from 1977-86).

Scenario A (2007 vintage)

$200 million of EBITDA
9x acquisition multiple
$1.8 billion purchase price
$540 million in equity, $1260 million in debt
Assume US$ Libor for the loan = 5.40%
Annual interest = $68 million
Maintenance capex = $25 million
Available cash flow = $107 million

Scenario B (1980s vintage)

$200 million of EBITDA
6x acquisition multiple
$1.2 billion purchase price
$156 million in equity, $1044 million in debt
Assume US$ Libor plus 300 for the loan = 8.40%
Annual interest = $87.7 million
Maintenance capex = $25 million
Available cash flow = $87.3 million

At first glance, although the 2007 deal needed more debt, the free cash flow figure is still higher based upon the attractive interest rate environment. But what happens if a recession hits in four years and EBITDA drops to $100 million?

In each case, let’s assume that all available cash flow went to reduce debt during those first four years of private equity ownership (although in the new KKR world most of it would have gone into growth plans), so the interest burden for year five is reduced in each case (I didn’t bother to take into account the interim decreases in interest costs as the debt is paid down each year – call it a rounding error; this is a blog after all, not Lehman Bros.). In Scenario A there’s $832 million of debt left, and in Scenario B its $695 million.

Scenario A (2007 vintage deal, four years later)

Recession EBITDA $100 million
Annual interest = $44.9 million
Maintenance capex = $25 million
Available cash flow = $30.1 million

Scenario B (1980s vintage deal, four years later)

Recession EBITDA $100 million
Annual interest = $58.4 million
Maintenance capex = $25 million
Available cash flow = $16.6 million

In each case, there’s still some cash left over for unforeseen circumstances, but despite the 30% equity slug — versus the “highly levered” 13% utilized in the 1980s — less than $14 million of cash flow separates the two scenarios in a recession climate. But, in the 2007 scenario the senior lenders are still exposed to $832 million in debt (which is a multiple of 11x recession EBITDA minus Capex) rather than “just” $695 million (which is 9.3x recession EBITDA minus Capex).

Which deal is more levered after all?

And if the rating agencies are right to be concerned about increasing bank hold limits and the commensurate portfolio concentration that follows from increased hold limits, then what happens when the four year fixed rate loan comes due? First off, interest rates have to remain stable for the firm to be able to support the new debt load. And second, the marketplace needs to have the same level of liquidity four years from now so that the senior lenders can sell down their stakes, should the need arise. Pretty key assumptions by the 24 year-old 2nd year Analyst working for the investment bank that’s advising you on your billion dollar buyout deal.

As a former CFO said once about a management consultant team doing some synergy analysis for his firm on an $800 million acquisition, “I’ve got shoes older than some of the people building these models”.

Mr. Kravis is still the Caesar of the PE industry, but the numbers look a lot more like the 1980s than he might want to admit.

MRM