Is the LBO Coming Back?

By: Bobby Dormanesh

During the first half of the year, the market continued to work through inflation, geopolitical instability, and rising interest rates. The IPO market was driven by a few large deals, but activity remained slow. As the market begins to shift toward moderate inflation, coupled with interest rate hikes slowing, coming to halt, or potentially reversing, financial sponsors are in a prime position to bring back one of their traditional investment models – the leverage buyout (LBO).

How does today’s environment impact tomorrow’s models?

Interest rate hikes have led to a slow down in traditional bank lending, valuation corrections, and another year of the “highest” levels of dry powder. Let’s breakdown each of these elements and how they impact future financial models.

Interest rates – Valuation models are pricing in future rate predictions. A short time horizon towards a decreased cost of capital will provide a boost in valuations. Furthermore, an opportunity to refinance debt at lower rates in the future creates potential for improved returns.

Valuations – Valuations froze or faltered as interest rates ticked up with no end in sight, resulting in stronger purchasing power for private equity firms. Sponsors are seeing opportunities to acquire portfolio companies at a reasonable price.

Dry powder – Every year, the market data shows continued growth in the amount of dry powder. There has been a slowdown in capital raising activity, but capital on the sidelines remains high and ready for deployment. As dry powder grows, fund managers continue to find creative solutions to put that capital to work.

The model in its simplest form is fairly straightforward. Buy an asset, optimize operational efficiency, refinance to decrease the cost of servicing debt, increase valuations as the cost of capital decreases, and then exit. Portions of the model related to interest rates were previously difficult to navigate because interest rates were close to zero, but the opportunity has now begun to re-emerge.