Cost of capital for private companies: stability in volatile markets

The dramatic rise in base rates over 2022 and 2023 has brought the cost of corporate debt into sharp focus and, together with a degree of caution on the economic outlook, led to some softening in demand by businesses for debt funding in 2023.

The actions of central banks and recessionary risks in the global economy have also sent public equity markets into spasms with share prices and capital allocations being impacted by the debates over hard vs soft landings, growth vs value and equity vs bonds. The IPO market has been one notable casualty of this volatility.

The private equity market has on the other hand got the luxury of a much longer-term outlook than the highly liquid stock markets and bond markets typically demonstrate. Target cost of private equity capital remains relatively stable with specific deal terms reflecting much more subtle influences in a time of economic uncertainty.

The traditional cost of capital hierarchy - private equity, public equity, debt, cash – is somewhat distorted currently with the cost of corporate debt climbing above the long-term return on public equity.

But there will be equilibrium again and, therefore, business decisions with long-term consequences should reflect long-term market norms.

Corporate debt: market price elasticity stretched by high base rates

Private companies have been enjoying the benefits of choice and flexibility from a much broadened debt market in the last decade. Asset Backed Lenders have expanded their repertoires and cash flow loans, unitranche structures and mezzanine debt have become increasingly available to SMEs and mid-market companies from alternative lenders and debt funds, providing welcome differentiation to a relatively risk averse banking market.

However, with debt pricing generally expressed as a margin over base rate or Sonia, the increases by central banks have had a direct and material monetary impact on servicing costs. This is most stark at higher levels of leverage where non-amortising strips and junior debt can have a marginal cost of finance well into double digits.

The result has been for debt levels to be tempered in some leveraged deals with higher levels of vendor rollover in buy-outs and revisions to terms – price and/or quantum of deferred consideration – in acquisitions.

Encouragingly the debt market is still very much open for business and whilst debt multiples might be trimmed for any perceived increase in business risk, margins have remained stable.

The base rate will fall of course from the current near-peak, probably earlier than the bond markets would suggest. Hence the financial pain should be short lived and the cost and disruption of a subsequent refinance needs to be considered before dialing down the leverage in a deal too far.

Businesses should as a minimum consider mechanisms within the deal structure that allow for an interim release of capital, or for preservation of debt capacity in a buy-out for a subsequent strategic acquisition, when cheaper debt can be accessed.

There is a need, therefore, for corporate finance advisers to demonstrate creativity to their clients in structuring deals in the current environment to ensure the best overall debt solution and strategy. ?

Private equity: high cost but calm heads

Private equity investment, whether for growth capital or to fund a buy-out, is typically on a five-year horizon. Funds are raised with a specified investment remit – sector, geography, deal size – and a target minimum return over a fund’s life span. Such target returns have been remarkably stable over the very long term and have been unruffled by financial crises, bubbles and pandemics.

Consequently, private equity funds can ride out the volatility in other capital markets and do not shift their own target return on capital, absent theoretically from a permanent change in the cost of other forms of capital, which is a very unlikely scenario.

The gap between mezzanine debt pricing and private equity cost of capital might have narrowed potentially impacting their relative attractiveness, but this differential will not be permanent.

Of course, in times of economic uncertainty, investment appetite towards particular sectors will vary, impacting the availability of funding for some businesses.

Also the use of debt in private equity deals has changed through cycles, being more attractive in a low cost, stable environment. The bigger the equity cheque in a deal structure where less is borrowed, the more dilutive the capital will be to existing shareholders.

In structuring a deal, a private equity investor is making judgements on growth, market outlook and likely exit valuation in order to project its expected return. Uncertainty dampens these variables and so the proportion of equity owned by the investor might increase in order to support the return thesis. ?

In short, the “pricing” in a private equity deal is a function of many variables, both empirical and subjective. Uncertainties and risks accentuate the need for rigorous preparation, robust business planning and as much corroboration of those variables and mitigation of perceived risks that a business and its corporate finance adviser can provide.

A level of competition in a transaction process can help counter the impact of residual cautious subjectivity and, together with creativity around earn-outs, equity ratchets, terms of any vendor rollover and use of debt, this should optimise the overall cost of capital in the transaction.

Long term goals and short-term noise

Strategic vision, business planning, ownership succession, management incentivisation and capital structure are long-term concepts. Market volatility can result in decisions being influenced by short-term noise but which have very long-term consequences.

Of course, some businesses will have the ability to delay a transaction for reasons of business performance or wider market conditions. However, for many others, opportunities to invest, acquire or exit might be lost. When the cost of debt capital is variable, the cost of private equity capital is stable, both forms of finance are available and there are a great many variables in a deal structure, this might be the wrong course of action.

Capital markets for private companies have become more complex and dynamic. Aligning business, shareholder and capital strategies should be the foundation of any transaction event. This requires market insight, structural creativity and collaboration between adviser and client to ensure both the optimal capital structure for a transaction as well as the post completion funding strategy.