What do rising interest rates mean to the buyout world? Let's take a hypothetical firm with $250 million in revenue. Let's also assume this firm enjoys a 15% EBITDA margin ($37.5 million). Light manufacturing firm with mostly inspection and assembly work to do, strongest brand in the industry. (These are pretty close to actual numbers for a deal Sub Rosa looked at). Such a firm is likely to go for between 6 and 8 times EBITDA. Forgetting for a moment how totally useless (and yet popular) EBITDA multiples are for judging rational pricing for an acquisition, that gives us between $225 million and $300 million in purchase price. Let's make the math easy and pretend a deal is struck at $250 million or 6.66x EBITDA and 1x revenue. Again, let's ignore how absolutely daft it is to be using EBITDA and revenue multiples for pricing.
This probably means that the capital structure is something like $125 million in senior secured debt. That's 3.33x EBITDA, which is pretty conservative. (We've been seeing 4.00x EBITDA for the senior tranche). Add another $75 million in junior debt which is 2.00x EBITDA and $50 million in equity which puts the debt to equity ratio at 4:1. Reasonable.
Zoom the way back machine to early October, 2005. Actually, let's make it October 1st, 2005. Interest on the senior secured and junior debt is generally based on 3 month LIBOR rates (as payments are quarterly). Senior secured had spreads of about 375-400 basis points (3.75-4.00%) over LIBOR. You could find LIBOR + 350 if you looked hard, but let's stick with 400 for now. Junior was around LIBOR + 650. October 1, 2005 3 month LIBOR for U.S. Dollar loans stood at 4.08%. That means the interest on the senior debt was 8.08%. The junior debt was 10.58%.
Senior debt interest per year: around $10 million.
Junior debt interest per year: around $8 million.
Total interest payments? $18 million per year.
Then there was the principal to be paid. Let's put that at a mandatory payment of $18 million per year. This is light, actually, but not entirely out of the realm of what one can negotiate. Of course, the point is that as you work down the principal, the debt payments lighten and you can work down more of the principal and the debt payments lighten even more and you can work down more of the... you get the idea.
Total debt service: $36 million or so.
This meant the company had about $1.5 million left after debt service to deal with extraordinary expenses, early debt repayment, etc. A bit tight, but not undoable. Let's assume the deal closes. Everyone is happy. Work begins.
Now run the clock forward to Feb 27, 2006. LIBOR has hit 4.82%. The company probably hasn't made any interest payments yet (often there is a 3-6 month gap after closing). The interest portion of the debt payments has risen to $19,515,000. With the mandatory payment of $18,000,000 total debt service is now $37,515,000, overwhelming EBITDA. The company barely is able to cover its debt service.
Run the clock forward to early April. LIBOR hits 5.01% (today it is at 5.08%). The company is $402,500 short for its debt service. Plus, with interest rates up, perhaps the economy is slowing a bit, depressing sales. Uh oh.
Think that's bad? A year ago, 3 month USD LIBOR was at 3.14%.
Now, this is a pretty silly example, for a number of reasons not least of being that one of the first things one does in an LBO analysis is an interest rate sensitivity calculation to make sure there's enough upward room to deal with these kinds of rate hikes. I have also cut some other corners that make this example a bit more glaring than it would probably be in the real world. I wonder, however, with all the fast-paced deal making, how many buyout deals bet the farm on low rates. Also, this deal isn't that highly leveraged. Debt to equity ratios hit 5:1 and even 6:1 in a few smaller deals I know about. Watch out. Raising a distressed and special situations fund seems like a wise thing to do just now.
