One of the key factors in the attractiveness of private equity investments it the cost of leverage that firms use to boost equity holder returns. Generally, private equity firms use a combination of senior bank debt (or bank credit facilities), senior bonds and subordinated (mezzanine) debt in order to increase leverage in their investments over what operating companies can sustain.
Private equity firms do this to increase returns to the point where they are attractive for their investors during a leveraged buyout transaction, which generally carries higher expected risk premium than owning a simple operating company.
Since most firms require all three components of debt to launch a successful acquisition of a target operating company, debt market conditions are important in terms of both the availability of credit and the cost of credit. If certain types of debt are not accessible, or the cost is prohibitively high, the private equity investment cannot make its hurdle rates to equity holders and the fund will not proceed. The most volatile of debt markets is the high yield or mezzanine financing market.
In recent years, the high yield debt market has quite literally come and gone at various times through the business cycle. In 2009, when debt investors feared putting money into any venture with even minimal risk due to the credit crisis, high yield spreads (the premium which the issuer pays over treasury rates) exploded, making such funding prohibitive for most firms. Private equity issuers only tapped this market through desperation, as high interest costs eroded equity returns.
Now, with treasury and high quality corporate issues paying historically low absolute coupon rates, debt investors are seeking out incremental yield wherever they can find it. One source is the high yield market, especially the high yield debt that investors can obtain from private equity investments. There are numerous deals being successfully placed in 2012, including Caesars Entertainment Corp. and Energy Future Holdings Corp, both which sport very low credit ratings.
The increased availability of high yield debt, as well as the other forms of private equity debt financing, has made a number of private equity transactions more attractive. Combined with over $1 billion in cash equity available to private equity fund managers, opportunities exist in all industries and jurisdictions for potential leveraged buyout and other PE transactions.
Private equity firms will require financial talent that understands the dynamics of target markets, industries and companies in order to provide the highest possible returns within their funds. These opportunities will continue to expand as debt markets stabilize further over the coming years.
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