Two weeks ago, the punditry was left scratching its head when in his annual Berkshire letter to investors, Warren Buffett - traditionally a huge bull on the economy and markets - said that not only were there no more bargain deals, but tacitly hinted that he is amassing record "dry powder" for when the markets tumbled, or as he put its "to withstand economic difficulties", so he can buy assets on the cheap.
It turns out the world's most famous investor is not the only one who is hunkering down. According to Reuters, private equity professionals are warning that today’s market could be as good as it gets, with comparisons to 2007's pre-crisis conditions becoming increasingly more common resulting in debates among industry figures "whether today's robust conditions constitute a bubble, as purchase prices rise, jumbo buyouts proliferate and deal terms become more aggressive."
Among the factors cited for market frowth are LBO multiples, which in 2017 hit a record high of 11.2x EBITDA up from 10x in 2016, according to Bain & Co.
Meanwhile, increasingly large buyout loans have been announced this year, including Blackstone’s $20bn buyout of Thomson Reuters’ Financial and Risk division, and the upcoming €10bn carve-out of Akzo Nobel’s specialty chemicals division: in fact, the average buyout size hit a new record of $675MM in Q3 2017.
Strong debt markets are currently seeing good investor demand, but private equity firms are targeting companies that they can take through a recession, Gregor Bohm, co-head of Carlyle’s European buyout business, said at Berlin’s SuperReturn conference. “You have to sell all the companies that you don’t want to hold through a recession,” he said.
Others were less diplomatic.
"I think we're now in bubble territory," said Frode Strand-Nielsen, founder of Nordic private equity firm FSN Capital, who added that the next five years could be a difficult environment for private equity and leveraged credits, particularly as buyouts that have been financed with cheap debt will get more expensive if interest rates rise.
“There’s a lot of financial engineering, which usually indicates we’re going into a concerning environment,” he said at SuperReturn.
Here, predictably, the biggest threat cited as facing the market this year is the spectre of monetary tightening as the European Central Bank ends its QE program...
... which as BofA explained recently, threatens to crush hundreds of European "zombie" companies which only exist thanks to unnaturally low rates.
If acknowledging there is a problem is half the battle, what happens next and will PE companies rush to dump their investments? Most likely not: Reuters reports that while private equity firms and bankers are aware that they are at the top of the market, "benign borrowing conditions could persist for some time, allowing borrowers to lock in cheap debt."
“Borrowers are enjoying peak funding conditions,” said Ed Eyerman, head of European leveraged finance at Fitch in London. And, apparently, the smart money believes that these unnatural borrowing conditions can last so long that there is no point in even being the first to sell for all the Margin Call fans in the audience.
Adding to the skepticism is that it was almost 5 years ago when some the biggest luminaries in the PE world declared the rally over. After all who can forget the words of Apollo's Leon Black who in May 2013 said that the Smart Money Is "Selling Everything That Is Not Nailed Down"
Little did he know that first QE from Japan, and then Europe, would follow.
Still, concerns are clearly rising fast again: co-president Scott Sperling said that Thomas H. Lee Partners is focusing on less cyclical growth businesses which are better positioned to weather a downturn that could have a similar magnitude to the last financial crisis.
“It’s certainly not a brave new world that includes no cycle,” he said. Worse, he said that the PE firm's "base case incorporates a recession of the size of 2008. The swings can be reasonably violent so you have to recognise how that could affect capital structures."
So is a correction or - more likely - a crash inevitable? The bulls naturally disagree, pointing to the global macroeconomic backdrop, which they claims is also stronger than 2007 and private equity firms are continuing to benefit from broad-based global economic growth, Sperling and Eyerman said.
Of course, there is a simple reason why everyone believes there is a strong "macroeconomic backfrop". Or rather, 20 trillion simple reasons:
Undaunted, the bulls go on:
Interest rates are rising, but are expected to stay lower for longer than before the financial crisis, which is unlikely to affect companies’ debt-servicing ability in the short term. Fixed charge cover ratios, which measure how comfortably businesses can meet operating costs, are also higher in leveraged companies than before the crisis.
The type of companies borrowing has also changed with the rise of software and business services with fewer assets and higher free cash flow margins, that require less onerous credit protections, Eyerman said.
“They don’t have the capex and fixed costs of pre-2007 leveraged credits in sectors such as auto supply and building materials."
And yet, despite lower (but rising) debt servicing costs, some still think the market's record nine-year bull run is simply delaying the inevitable correction, which will only make it more painful.
"We’re watching a movie where we know what the ending is,” said Guthrie Stewart, global head of private investments at PSP Investments. “Just not how long it is until we get there."
Ironically, he echoed almost verbatim what Citi's notoriously skeptical chief of credit, Matt King, asked rhetorically over the weekend: "we know what central banks are doing... why are we so slow to price that in."