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The dire need for acquisition financing

by Imad Ghandour

Private equity in the region is like a limbering man: almostall acquisitions of this $20 billion industry are beingfinanced directly from the coffers of the private equityfunds. It is the good, old way of investing, but somethingthat has been abandoned a long time ago in other parts ofthe world.

What is missing from the private equity secret potion is thepower of leveraging: using less expensive debt to financeacquisitions instead of using the more expensive equity.Take an example: Suppose a company is acquired for $100million by equity only (ie all the $100 million came fromthe private equity fund) and is sold at $130 million in oneyear, then the IRR is 30%. However, if the same investmentis financed by $50 million bank loan at 10% interest rate,than the remaining $50 million invested directly from thefund own pocket will be returned as $75 million aftersettling the loan and the interest of $5 million, thusyielding an IRR of 50%. This is the power of leveraging!

With relatively low interest rates on the US dollar and thecarry trade from yen to other currencies, it became veryattractive to use debt to finance private equityacquisitions. Today, more than 80% of an acquisition isfinanced by different flavors of debt, and 20% is financedby the fund’s own money. With record global private equityvolume of $650 billion in 2006, the acquisition financemarket has ballooned to reach more than $400 billion.

Mezz & Co

In order to drive the maximum benefit out of leveraging,private equity players have perfected the art of leveragingnot only through traditional bank financing, but throughusing mezzanine financing as well.

A typical private equity deal will have several layers ofdebt put on top of each other in order to reach the maximumlevel of debt based on the companies operating cash flowswhile at the same time optimizing the interest and principalpayments. A typical deal will have two layers of senior bankdebt, one amortizing quickly and another one with back-endedpayments. On top of that, there will be several layers ofmore exotic debt: second lien debt, subordinate unsecureddebt, high yield bonds, mezz debt with equity kickers,preferred shares, etc.

Commercial banks are the typical suppliers of senior(secure) debt. The more exotic flavors are supplied from anincreasingly diversified group of financial institutions.Pension funds, insurance companies, and endowments will beseeking to have higher yield debt with long tenors in orderto meet their long term obligations. There are also aspecialized number of mezzanine funds, and hedge funds areone of the newest entrants, seeking complex structures thatwill yield even higher returns.

Middle East is still behind

Unfortunately, the debt providers in the region are stillbehind in this area Most PE transactions in the region arestill financed largely through equity due to the limitedavailability of proper debt financing, and less than 10% ofPE transactions are leveraged at the target company level.

The limitation of debt financing in the region is drivenby a limited understanding for the PE asset class by lendinginstitutions, shallow debt capital markets, andunsophisticated lending focused on balance sheet assets,collateral and personal or mother company guarantees. Thesefactors are leading PE firms to seek financing frominternational players while others are attempting to educatelocal lenders on the concept of cash flow based lending.

Given that it is expected that the private equity industrywill have $20 billion of assets under management in 2007,Arab banks simply cannot ignore the opportunity to financeacquisitions. International banks are starting to offerlocal PE players this product, and local banks have startedto take notice. Given the attractive margins on acquisitionfinance, local banks will sooner or later set up specializedunits targeting this niche. However, the more exotic formsof debt, like mezzanine, will probably take slightly longerbefore becoming readily available in the region.

Imad Ghandour is Principal – Gulf Capital andHead of Information & Statistics Committee –GVCA

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