What terms are currently being offered to management teams by private equity investors and how have these trended over time? Do they differ depending upon deal size or deal type?
Using data collected from private equity proposals to management teams covering the period from 2006 to the end of 2015, we have analysed some of the key metrics and trends.
The data over this period comprises over 100 different proposals put to management teams from some 70+ different private equity investors, ranging from lower mid-market primary management buy-outs to large cap tertiary auctions. While the businesses are UK or European based, they are from all sectors of the economy and the private equity investors from the UK, US and Europe.
In this article we look at preferred returns, which in the UK are typically referred to as loan note yields but are sometimes referred to as PIK note coupons, preference coupons etc. Economically they all provide a preferred return on the investment made by a private equity investor, which accrue (or are occasionally paid) over the life of the investment, increasing the hurdle above which equity value is created.
In future articles we will look at other terms covering base sweet equity, ratchets, management rollover, target returns and transaction fees.
Key Findings – Preferred Returns
The average loan note yield across all deals since 2006 was 10.7% with some marked differences across the deal sizes. While deal sizes over £250m had an above average 11.2%, those under £100m averaged 10.8% and those in the £100m to £250m range had a below average 10.0%.
The lowest loan note yield (where it ranked ahead of equity value) was 8% with the highest an eye watering 17%.
Whether the deal was a primary or secondary (or even tertiary) deal made no statistical difference with the average for the former 10.68% and the latter 10.72%.
The majority of loan note yields compound annually with some outliers at semi-annual or quarterly compounding.
The average loan note yields in the last five years have shown a general trend downwards from 11.2% in 2010-2012 to an average of 9.8% in 2015.
Loan note yields and sweet equity offered to management teams are financially interlinked as both combine to drive private equity investment returns. Many of the US based private equity investors do not have prior ranking preferred returns in the waterfall of exit proceeds allocation, meaning that once they have their initial investment back the sweet equity is “in the money”, unlike traditional UK structures where the sweet equity ranks behind the compounding loan note yield.
Consequently, the interaction between sweet equity offered and the compounding loan note yield proposal must be modelled to understand the economic impact of these on the overall returns for both private equity investors and management teams. High loan note yields, particular coupled with regular (e.g. quarterly) compounding, will put a significant hurdle ahead of any sweet equity before it is “in the money”. Conversely a relatively low sweet equity proposal combined with no prior ranking preferred return will mean any sweet equity will have value at an earlier point along the range of future exit valuations.
Higher average loan note yields in deals over £250m compared to those below this deal size, in part reflects the relative competitive landscape and number of deals in each segment but also the fact that bigger absolute returns for management can be achieved with smaller sweet equity percentages.
The trend in the last few years down to 10% loan note yields or below is a welcome shift in the market driven by a combination of factors including a long period of relatively low global interest rates and competitive tension between private equity investors, with average base sweet equity allocations remaining relatively constant through this period.