Recent worries about the state of the debt markets have put a very fine point on risk in the private equity portfolio. Whether these companies can handle all the debt they’ve taken on in recent years is what everyone wants to know.
No one is more interested in staying on top of this question than the buyout GPs themselves. Inexpensive debt has been a blessing on the deal front and in the form of dividend recapitalizations. But as the liquidity in the debt markets recedes, no GP wants to be caught without a swimsuit. Far from it – GPs today must increasingly show an ability to monitor risk in the portfolio in a systematic way.
“If we’re doing our job, which is staying on top of the company, what can go wrong with the debt?” asks Scott Edwards, a vice president at Sun Capital Partners, a Miami, Florida-based distressed private equity investor. “The real question is: how are you managing the performance of your company?”
As private equity firms have grown and the industry has matured, GPs have become more systematic in the way they track the companies in their portfolios. Many private equity firms now request periodic and standardized reports from the management teams at their portfolio companies. In these reports are metrics that GPs track on a regular basis that serve as an indicator of the health of the company. Key metrics include the portfolio company’s leveraged ratio, fixed charge coverage ratio and interest coverage ratio.
What GPs really want from management and financial reports are numbers that tell them, among other things, how likely it is that the companies are going to get into trouble with their lenders.
Many private equity firms still leave portfolio company monitoring in the hands of the deal partner or an operating partner responsible for the company. Some firms, however, are moving beyond this GP-by-GP approach, and beyond the lowly Excel spreadsheet; they are centralizing the tracking function with sophisticated, customized systems, sometimes called “dashboards.”
This trend is being accompanied by a related trend for firms to appoint individuals to specifically manage all financings for new acquisitions and at existing portfolio companies.
Early and often
Few GPs admit outright that they are worried that a tightening in the debt markets will spread to affect their portfolio companies negatively. But keeping a close eye on the performance of their portfolio companies is all the more important in these risky times.
For monitoring, GPs rely on regular reports from portfolio companies. In general, “[d]ebt is monitored quarterly, while some businesses are monitored monthly,” says Angela Fontana, a partner in the Dallas office of law firm Weil, Gotshal & Manges, who has advised DLJ Merchant Banking, Thomas H. Lee Partners and HM Partners. “Sponsors also get periodic monitoring packages, which will typically consist of monthly financial statements, quarterly financial statements and annual audited financial statements, along with the management discussion and analysis (MDNA) of the business.”
These reports are used by firms to check the pulse of the portfolio companies. Different GPs say they monitor companies at different intervals. Many require monthly reports, but weekly reports are not uncommon. Monitoring also depends on the state of a portfolio company – Sun Capital may look at a poorly performing company as often as daily, says Edwards, whereas companies that are performing better may only need to report monthly.
“Monthly snapshot reports” is what Matthew Janchar, director of capital markets at Berkshire Partners, a Boston private equity firm, says he uses to isolate trends in operating performance and track debt servicing issues. “It certainly facilitates my ability to monitor and optimize our capital structures since I can refer to detailed portfolio company reports that are always current.”
Janchar adds that communication between Berkshire and its portfolio companies can occur more frequently, “from frequent informal calls and meetings to highly-structured planning sessions and monitoring.”
At Lincolnshire Management, a New York private equity firm, monitoring is conducted weekly, in the form of reports that form the basis of weekly discussions with management of the portfolio companies.
“As a result of weekly calls, we’re having an active dialogue with the projects management teams focusing on their concerns, their successes, their struggles,” says Allan Weinstein, a managing director at Lincolnshire. “We have an opportunity to talk about the projects we’re working on with the business, whether it’s add-on acquisitions, industry research or information about financing.”
By the numbers
What GPs really want from management and financial reports they receive from portfolio companies are numbers that tell them, among other things, how likely it is that the companies are going to get into trouble with their lenders.
Even for a firm like Baltimore, Maryland-based growth capital firm ABS Capital, which does not take on additional debt when making an equity investment, chief financial officer James Stevenson, says, “For the most part we get monthly data from our companies where they report certain key financial figures that we track. At a minimum it’s cash, debt, revenue and EBITDA.”
Stevenson continues: “We’re monitoring those figures and updating our database. If we see the debt level relative to EBITDA gets out of line, then we’ll want to have the partner involved with that company explain that and work with the company on that situation.”
The emphasis on debt is greater for firms that do buyout transactions. Janchar, who is director of capital markets at Berkshire, says: “in general, I tend to focus on the two points that relate most directly to control: covenants and call protection.”
For cash flow-based loans, covenants are particularly important. The key ratios GPs monitor for these types of loans are those related to EBITDA: leverage, fixed charge coverage and interest coverage. When a company approaches the covenant level, GPs will talk to the lenders.
On the other hand, monitoring is less crucial for asset-based loans. “It’s not critical to set up a process to monitor an asset-based loan because it’s self-monitoring,” says Stevenson. “If receivables or inventory goes down, line of credit goes down. The bank is limiting how much the loan the company has based on its receivables or inventory balance.”
Many things can go wrong in the course of a company’s growth that could trip up a GP’s best-laid plans. Hence, relationships with lenders are crucial. “We treat them as partners,” says Edwards. “We have news, they get the news. Because of the types of deals we’re doing, it’s not uncommon to have a bump in the road. We want to repeat business with these banks; we keep an eye out for them. We also support our companies and try to work with the banks.”
In trying times, lenders may choose to loosen the covenants or seek increased compensation either through a fee or through an increase to the interest rate on the loan.
Loosening covenants on a loan can give companies – and GPs – potential downside protection in the event of a market or industry correction, or even to ride out business cycles. GPs have sought “cov-lite” deals – loans with one or no financial maintenance covenants – but there has been a recent push back in the market on such transactions.
The key for GPs, says ABS Capital’s Stevenson, is to work with the lender, usually to buy time for the company to change its plans to allow it to generate cash to get back into compliance with the terms of the loan.
GPs also monitor other metrics that indicate a company’s health. Lincolnshire tracks working capital accounts such as inventory, receivables, payables and accruals, just as “closely as we monitor revenue and EBITDA of a company,” says Weinstein. Sun Capital, which focuses on underperforming and turnaround companies, can also monitor sales figures and pipeline, cash flow and strategic initiatives, whether these be acquiring a new customer or consolidating facilities.
In whose hands
With the reports and metrics from portfolio companies multiplying, who in the private equity firm is ultimately in charge of monitoring these performance indicators? For most private equity firms, this responsibility mostly falls to the partner who executed the deal.
Depending on the private equity firm’s model and size, however, debt monitoring can be done by operating partners or at a centralized level. At Sun Capital, the firm’s 22 senior in-house operators – professionals who work with management teams at portfolio companies – are responsible for supervising portfolio company performance.
Monitoring of the financial performance of portfolio companies is centralized at The Blackstone Group. In 2005, the firm hired James Quella, senior managing director and senior operating partner in its corporate private equity group, to monitor the strategy and operational performance of the firm’s portfolio companies.
At the University of Pennsylvania’s Wharton Private Equity Conference in 2006, Quella disclosed that Blackstone has an automated web-based reporting system which all its portfolio companies use. The information entered into the system is then analyzed centrally.
Although the concept of centralized monitoring “dashboard” has not been adopted on a large scale, private equity firms are beginning to move in that direction. A GP at a buyout firm considering building a financial dashboard to monitor the performance of its portfolio companies says he has two concerns. One, that the portfolio companies will not use the system to input relevant metrics on a timely basis, and two, that the partner currently responsible for the company will feel as though the firm is stepping on their toes.
The monitoring of the health of the portfolio is being aided increasingly by partners who specialize in providing capital markets services to portfolio companies. In an earlier interview, Berkshire’s Janchar said: “[my] role reflects recognition of the increasing complexity, innovation and creativity among the sources and structures of capital that are now available to private equity investors.”
Another firm which has a head of capital markets is Warburg Pincus, which hired Christopher Turner in 2005. The capital markets team executes debt and equity financings across the firm’s portfolio. Turner is also responsible for managing the firm’s commercial and investment banking relationships.
Should private equity suddenly enter a new era of declining returns and multiplying risks, the services of those who can help limit the downside will be in high demand.