In recent years, manipulated low interest rates and the emergence of a “shadow” banking sector has provided the PE industry with favourable conditions to access cheap debt. The environment has now changed, and we expect PE to use less leverage than in the past decade to generate their target returns.
Public markets are uncomfortable with higher levels of leverage, regularly de-rating companies on this basis. The opportunity typically resides when a balance sheet is stretched, but not distressed, which has led to a reduced valuation on the equity to compensate for elevated financial risk.
If the operational plan and strategic actions can accelerate the reduction in leverage, then multiple expansion will ensue and value to equity shareholders rises, often itself in a geared fashion.
A fully repaired balance sheet provides a further attraction to those parties interested in providing the exit option to shareholders.
Richard Staveley is portfolio manager of the Rockwood Strategic Investment Trust
