Since the 2008 financial crisis, the US Federal Reserve and other central banks in Europe have pumped trillions of dollars into the financial markets. Notwithstanding the amounts injected, a liquidity crunch in 2016 is unavoidable and could have a significant impact on available financing for PE sponsors.
Several regulatory factors point to this liquidity crunch, including new financial regulations that demand higher capital and liquidity requirements from banks, which must hold more cash in reserve. Basel III, for instance, requires banks to maintain certain liquidity coverage ratios such that they have high-quality liquid assets that cover total expected net cash outflows over 30 days. Similarly, the Board of Governors of the Federal Reserve has brought in significantly tougher liquidity requirements for the larger bank holding companies in the US. In addition, increased enforcement of leveraged lending guidelines means that US banks are no longer as active in the syndicated markets as they once were, and are no longer in a position to hold certain riskweighted assets on their balance sheets.
The reduction in liquidity and corollary increase in cost of available financing will have a profound impact on PE sponsors’ strategies. Since large institutional lenders are shying away from targets they perceive to be riskier, whether due to the industry involved, lack of market familiarity with the target in the case of carve-out transactions or because of leverage levels, private equity firms looking to tap traditional financing markets are likely to continue shifting their focus to lower risk targets. Banks are expected to be more willing to provide financing for lower risk targets in an effort to ease risk-related concerns tied to regulatory requirements.
With PitchBook’s 2016 Crystal Ball Report indicating that traditional banks will only account for some 40% of overall debt financing during the year, PE sponsors may be forced to look at non-traditional sources of finance, including mezzanine lenders, business development companies, other private equity firms and corporate financial sponsors. New sources of capital include both private companies and debt funds: Koch Industries’ investing arm, Koch Equity Development, recently made a preferred investment that served as part of an overall acquisition financing package; and French buyout firm Eurazeo financed their acquisition of Fintrax with €300 million provided by Ares’ direct lending arm, the largest amount lent by a single debt fund on a deal in Europe to date.
Many US PE firms may also take advantage of the “Reverse Yankee” phenomenon. In the last several years, we saw many European sponsors accessing the US leveraged loan markets because of attractive pricing and significant operational flexibility from Term Loan Bs. Although much of the regulatory regime will also affect European banks, there are still opportunities for US PE firms to look “across the pond” for access to capital in an environment where US regulators are further restricting the banks’ ability to pump liquidity into the markets.
Alternatively, PE sponsors may decide to write-out higher equity checks when acquiring assets. Apollo Global Management, alongside several other PE groups, recently took Apollo Education Group private in a transaction with no debt funding. The entire transaction was equity funded at closing, and leverage may be added when debt markets improve. According to Preqin, there has been a steady rise in 100% equity funded deals since 2005 as seen in the chart above, and we anticipate this trend will continue in 2016.
Although these liquidity constraints create a challenging environment for PE firms, the outlook for transactions is still positive. The level of dry powder available to private equity funds reached US$752 billion at the end of 2015, according to Preqin, and will continue to grow in 2016 with additional fundraising activities planned. With the enduring uncertainty in the financial markets, PE firms will simply need to be creative in leveraging all of this unspent capital.