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Opportunistic Investing: Unsustainable Private Market Capital Structures

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  1. What is an unsustainable capital structure? Translation: Too much debt.
  2. How have the Fed’s interest rate increases impacted private businesses with high debt levels?
  3. What is the opportunity for patient investors?

One of the most well-known quotes from one of the greatest marketers (and investors) of all time…

“You never know who’s swimming naked until the tide goes out.”


– Warren Buffett

Consider an oversimplified example:

  • A private equity firm acquires a business that produces $10 million of EBITDA.
  • The transaction is financed with debt equivalent to 6.5x EBITDA or $65 million, with an interest rate that is variable based on SOFR (essentially Fed funds rate) + 600 bps.
  • SOFR of 1% + 600 bps is a 7% interest rate in this example, which is $4.55 million of interest expense ($65 million * 7%).
  • However, after the Fed’s interest rate increases, SOFR is now nearly 5.5% and the company’s interest rate is 11.5%! This leads to an interest expense of $7.5 million.
  • Now further imagine the business has been impacted by economic or competitive forces or a lost material customer that causes EBITDA to decline 30% to $7 million. Keep in mind this was a $10 million EBITDA company, which is tiny and carries large sustainability risk…it’s not Microsoft!
  • $7 million of EBITDA vs. $7.5 million of interest expense is a problem.

The example above can lead to compelling investment opportunities. For instance, the private equity firm might conclude the lower level of EBITDA also deserves a lower valuation multiple, hence, their equity ownership interest is virtually worthless. This type of situation presents an opportunity for new capital to restructure the debt and acquire the equity at a distressed value.

At Essential Partners, we are not anti-private equity nor are we predicting a private equity bust. In fact, we have a lot of respect and friends in the industry and admire the historical record of many firms. Zero interest rate policy can lead to a gross misallocation of capital and too much debt across asset classes (real estate also comes to mind). Essential Partners invests a portion of our client partners’ capital opportunistically in strategies that will benefit from unsustainable private market capital structures.