Since the end of last year, the three-month London interbank offered rate, known as LIBOR, has increased to 2.32% from 1.69%. LIBOR measures the cost for banks to lend to one another and is used to set interest rates on roughly $200 trillion in dollar-based financial contracts globally, including almost all LBO financing. Throughout most of my career, 3 month LIBOR has been falling from almost 10% in 1989 to less than 1% in 2015. Since then, it has inched forward, but recently has accelerated. We typically borrow for our businesses at LIBOR + 350. In 2015 that meant 3.8 %. Today it is 5.8%.
Six Times Leverage Is Common
A majority of the buyout financing is variable rate debt priced off LIBOR. Since the debt has been cheap, there is also a continuation of the trend by private equity firms to use more and more debt in the capital structures. Here is a chart from The Wall Street Journal Daily Shot on April 2 showing the rising amount of debt in the LBO capital structure. Notice that more than 50% of the deals have greater than 6x leverage:
Trump Tax Reform May Hurt The Model
It is still uncertain whether Trump corporate rate cuts will compensate for the rising interest expense. Also, for the first time in my career, the new tax law imposes limitations on the deductibility of interest in highly leveraged capital structures. That provision limits interest deductibility to no more than 30% of EBITDA. If you run a financial model on a $50 million EBITDA business that has 6x leverage ($300 million debt) at a blended rate of 8% that would mean $24.0 million of annual interest expense against a 30% annual deductibility limit of $15.0 million. $9.0 million of interest would not be deductible and taxable income for the LBO company would increase by $9.0 million. Even though corporate rates are now lower (21% vs 34%) it won’t take long before the net cash to pay principal will be worse than before tax reform.
This is mostly because, the deductibility of LBO interest will fall again in 2021 when the 30% limitation is applied to EBIT (a much smaller number) not EBITDA. There is also a risk of large disallowances for cyclical companies whose earnings fall dramatically.
Valuations May Fall
The bottom line for leveraged buyouts is less taxpayer subsidy, less cash flow, and, maybe, a corresponding decrease in valuations? For the entire period I have been involved in leveraged buyouts since 1999 ,100% of the interest expense has been deductible. Leverage has been encouraged and rewarded.
Rising interest rates and limits on deductibility of interest are major changes in our business model and it comes just as interest rates are rising for the first time since 1982. A recent study by Goldman Sachs confirms my concern. They have demonstrated that shares of 50 public companies whose floating rate bonds account for more than 5% of their total debt have lost 5% of their market value through March of 2018 compared to an overall index decline of 1%. This report is confirmed by The Wall Street Journal Daily Shot which shows this trend for Kraft and General Mills compared (high variable rate debt) to the SPX and Black & Decker.
If the variable rate is a major problem for valuations of public companies with small exposure, what does it portend for private equity firms with 10x the variable debt exposure? The public markets are signaling that variable rate debt is a valuation issue. When interest on LBO debt may be a non-deductible as well you may see the first valuation “double whammy” in a long time. The debt magic may be done.
