Respect the Tides: Dangers of Rising Leverage in Late-Cycle LBOs


August 02, 2018

Serious beachgoers take their strategy quite seriously. Preparations include packing sunscreen, towels, shovels, umbrellas, games, water, and the snacks that are inevitably craved at some point. Once at the beach, one must decide where to set up chairs and the aforementioned gear for the beach day ahead. Aspects of the ‘where to sit’ decision include navigating potential throngs of other beachgoers, lifeguard stands (if strict rules limit swimming only around the stands), and tides. Beach pros prepare by knowing that day’s timing of high and low tides. Setting up chairs too near the water around low tide leaves the beachgoer destined to be overrun by waves within hours. Chairs too far from the water create long walks, higher likelihood of insects being a bother, and scorching hot sand. Optimal beach strategy threads the needles of these challenges as proper chair placement is not about where the water line and throngs of people are right now but where they will be over the course of the day, particularly at high tide. This same preparation has parallels to credit investing where, instead of tides, investors must anticipate market and economic inflection points that affect both fundamentals and valuation. Unprepared, living-in-the-moment investors leave themselves exposed to the investment market tides.

In the beach example, imagine two choices of seat placement exist, Point A and Point B. During low tide, Point B appears the perfect combination of cool sand and close proximity to ocean water. However, when the tide comes in, the beachgoer sitting at Point B would be underwater. The other option, Point A, may appear too far away, however the location will become prime property at high tide. Well-strategized chair placement also factors in some incremental room for a random rogue wave that could push the water line briefly higher. That incremental room is akin to a safety buffer. As the day progresses, the beachgoer at Point B will soon regret their position, forced either to move or to sit among the waves, envious of the beachgoer at Point A.

Investment Market Tides

As investment cycles lengthen, recency bias emphasizes economic growth, subdued volatility and widespread availability of credit. In fact, no investment professional under the age of 32 was even a college graduate during the last financial downturn in 2008. This inexperience and the false confidence it inspires has facilitated rising valuation and leverage metrics. The chart below shows historical corporate valuation trends, including private company valuations that highlight the cyclicality of valuation, rising over the course of a market cycle only to fall during a correction. It also highlights how public market valuations have reached levels not seen since the late 1990s.

Enterprise Valuation Multiple

Source: Bloomberg, S&P LCD

Valuation Multiple Change YoY

Source: Bloomberg, S&P LCD

This trend reminds investors that what goes up also comes down as peak market inflection points mark the turn toward declining valuations (i.e., cash flow multiples) at the beginning of the next phase of the market cycle. For example, peak-to-trough private (i.e., LBO) valuation multiples fell by a 1.2x cash flow multiple in 2001 vs. 1999 and by a 2.0x multiple in 2009 vs. 2007.

Economic cyclicality also affects corporate valuations as slower economic activity leads to reduced revenues and cash flow. Using S&P 500 metrics, EBITDA fell by 13% from 2000-02 and by 31% from 2007-09, highlighting the interconnected nature of economic and investment cyclicality. The use of public market data is helpful given the availability of regular fundamental information as a proxy for how the economic and investment cycles would similarly affect private companies.


Source: Bloomberg

Private equity sponsor LBO financing decisions are typically made in rising market conditions ahead of an inflection point. These decisions occur amid robust confidence and abundant borrowing availability. In the current credit markets, a ‘typical’ LBO financing comprises ~5.0x secured leverage, 6.5x overall leverage (or 1.5x of incremental leverage via unsecured debt), and ~9.8x overall enterprise valuation (vs. EBITDA).

Source: TCW

To illustrate the vulnerability to market inflection points, the sample capital structure is shown above. An adjustment for the aforementioned valuation multiple contraction (~1.6x lower) highlights the effect on equity valuation, in particular by nearly 50%.1 A separate fundamental adjustment for reduced EBITDA (~22% lower) shows a different headwind using the previously-mentioned S&P data as a proxy.2 Lower EBITDA translates into both higher leverage and an equity correction of potentially 65%. Both are particularly negative for prospective equity valuation and worrisome for credit investors given the reduced equity-subordination, or excess buffer/cushion for an unexpected development akin to a rogue wave. Experienced investors know these effects occur simultaneously following peak market inflection points. The above/right scenario combines the lower valuation multiple and fundamental headwinds of reduced EBITDA, resulting in the equity potentially becoming worthless and the unsecured debt now the fulcrum, or effectively the go-forward equity position in the capital structure. This is meant to serve as an illustrative example of a hypothetical capital structure and the pitfalls of excessive leverage leading into a peak market inflection point.

If this were to occur, the valuation adjustments would be dramatic. Confident investors who rushed in to invest at the LBO inception would be left humbled, surprised by the severity of the correction. What that overlooks is that while the exact timing cannot be predicted, market cycles are inevitable. Much like tides, investment markets are cyclical and mean-reverting. Ebullient confidence and aggressive investment strategy in the face of late cycle dynamics are not unlike the novice beachgoer deciding to sit near the water’s edge during low tide. Inevitably they will get washed out by the pounding of punishing waves. The beachgoer prepared for high tide likely looked overly cautious during low tide but is at precisely the optimal location when the tide comes in. Astute investors are akin to well-prepared beachgoers who focus not where the current water level is but instead on where the tide is going.

1 Private EV/EBITDA multiple contraction was ~1.2x in ’01 cycle and ~2.0x in ’08 cycle. Average multiple contraction is ~1.6x.

2 EBITDA contracted 13% in ‘00-’02 cycle and ~31% in ‘07-’09 cycle. Average EBITDA contraction is 22%


This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. © 2019 TCW