Coming Downturn. Cranking Leverage. What Could Go Wrong?

Private equity firms have a gloomy view of the markets, but deal activity is strong — and they’re still leveraging up their portfolio companies.

According to a survey released today by advisory firm BDO, 89 percent of private equity respondents said they expect a long downturn in the next two years, with almost a quarter of those expecting a correction in the next six to twelve months.

Seventy percent of the private equity executives surveyed say they are being more “selective” when analyzing richly-priced investments, but the active market for deals suggests they’re still deploying plenty of the money they’ve raised over the past few years, reported BDO in its tenth annual Private Equity Perspective Survey.

Fourteen percent of private equity firms say they’re now holding investments for longer than average periods, and only 8 percent, down from 13 percent last year, are exiting portfolio companies.

And they're still in love with leverage. In this year’s survey, BDO asked private equity firms for the first time about debt and new companies. About one-third of sponsors said they’re putting more debt (more than 3 times EBITDA, or earnings before interest, taxes, depreciation, and amortization) on new companies, while one-quarter say they’re using average leverage, in the range of two to three times EBITA. 

[II Deep Dive: Private Equity Firms Aim to Raise More Cash This Year Even as Margins Shrink]

“Debt markets remain strong despite nerves around a recession and leverage is still very much on offer,” wrote the report’s authors. “But to survive the next recession, PE firms will need to take a more conservative approach to structuring deals and sensitize acquisitions towards a recession scenario.” 

In the private equity world, the way firms use debt can be the difference between success and failure. The BDO survey found that one-third are using debt for dividend recaps, which pay a special dividend to shareholders, and only 14 percent are refinancing debt.

Only 17 percent are investing in the operations of their portfolio companies, which is notable given how important the improvement of underlying businesses has become to investors’ overall private equity returns.

A small number—16 percent—are not planning to increase leverage. Last year 44 percent said they were not planning to increase the amount of leverage on their portfolios. 

Sixty-one percent of private equity firms surveyed said they expect deals to come from private company sales or capital raises. Twenty-one percent said exits by private equity firms would be the key driver of deal flow, which BDO said was consistent with survey findings over the past two years.

“This finding seems to indicate a trend that PE firms are sourcing most of their deals from founder-owners, not other PE firms or corporate divestitures,” wrote the report’s authors. The advisory firm said this type of activity will increase with baby boomers retiring.