In a free market economy, participants try their best to take advantage of return opportunities. In theory, these opportunities should not survive long in liquid markets, but the lending environment over the past 24 to 36 months has been operating in direct contradiction to this principle as private, risk-based debt providers (dedicated debt funds, specialty lenders and offshoots of traditional hedge funds) have significantly raised their profile and increased lending volumes. When traditional cash flow lenders tightened their purse strings, a large amount of capital exited the market, and these risk-based debt providers were able to extract abnormal returns on capital that traditionally fell in the senior tier of the capital structure. Recently, however, traditional asset-based lenders and emerging sponsor-focused lenders have begun to fill the void with stretch products and senior cash flow offerings. This group of lenders is bringing the supply side of the debt market back into line from a cost perspective, and may be paving the way for a return of the M&A market.
The Market Backdrop
The last three years have seen a drop-off in leverage ratios to their lowest levels since the blossoming of institutional private equity in the 1980s. While this decline was to be expected in the face of an economic downturn, the magnitude of the decline was even greater than it was in the U.S. from 1990 to 1992. During the Gulf War and the concurrent recession, total leverage multiples dropped from a heady six to nine times EBITDA in the late 1980s to approximately five to six times. Even in 1992, the leanest year, the trough barely dipped below five times EBITDA. The period from 2000 to the present, while similar in many respects to this earlier period-with recession, war and sharp decline in equity markets-saw total leverage ratios drop below four times EBITDA.
The most surprising trend, however, has not been the decline in overall leverage ratios, but the sharp increase in the cost of senior debt, even in the face of historically low interest rates. The biggest reason for this trend has been the sharp decline in cash flow lending, which shifted the bulk of the market to asset-based lenders and tightened credit availability. While our experience in the market would indicate that pricing of asset-based deals has been very competitive, historically normal leverage ratios just aren’t achievable using the typical asset-based lender formula. Take, for instance, the hypothetical $100 million in revenue manufacturing company with a 15% EBITDA margin, 60 days in receivables and 90 days in inventory. Historically, this company would have been able to raise at least three times EBITDA in bank debt, or $45 million. In the current environment, asset-based lender ratios of 85% of receivables and 65% of inventory yield $30 million of debt availability, or a full multiple of EBITDA below historical norms.
Without alternative sources of capital to fill the gap, the door remains open for risk-based lenders to provide the capital necessary to close deals. These lenders are targeting and receiving low- to mid-teen returns on senior and senior subordinated debt that was once priced at a moderate spread to Term A senior debt. While this capital has provided much needed financing in recent years and is less costly than the typical mezzanine capital cost of high teens to low twenties, there is a dramatic gap between returns on these products and those of traditional senior debt.
New Products to the Rescue
Sensing a market opportunity, asset-based lenders have begun to lend beyond their traditional formulas and earn a higher return on capital while maintaining a relatively low-risk profile. Their asset-based counterparts in the commercial banks such as PNC, BankOne and Bank of America are doing the same. While this activity from the commercial banks may signal the first signs of life from traditional cash flow lenders, most feedback we receive is that asset-based lending (ABL) stretch lending is being driven more by a market opportunity than any strategy of lending institutions to re-enter the cash flow market. Additionally, new sponsor-focused entrants and some non-regulated asset-based groups have begun to offer cash flow pieces to buyout sponsors while commercial bank cash flow lending has remained thin.
The stretch pieces being offered by asset-based lenders are currently priced at a 350 to 600 basis point spread LIBOR, which in today’s world means 4.50% to 7.00%, or very inexpensively priced money relative to the risk-based lending sources with low- to mid- teens pricing. Senior cash flow deals from the sponsor-focused cash flow lenders are coming in at a 250 to 500 basis point spread LIBOR and lending multiples are reaching as high as three times EBITDA. The new willingness of senior ABL lenders to add to their exposure, even if only incrementally, will hopefully help ease the capital crunch experience by private equity funds during this down market.
While the emergence (or reemergence) of these products does not represent a complete return to normal lending practices, the asset-based stretch lending and sponsor-focused cash flow products should prove to be a breath of fresh air for private equity funds. The typical ABL stretch lender is now looking to extend a cash flow line equal to 20% to 30% of a total credit facility, which in traditional cash flow terms generally adds another 0.5x EBITDA and in select cases 1x leverage on top of a traditional asset-based facility. At 400 or more basis points less expensive than the alternative source of capital, this structure has the potential to boost investment IRRs by two percent. In today’s environment, even this modest increase in returns is important. The senior cash flow products should have an even greater impact on deal economics.
What Happens when Traditional Cash Flow Lenders Return?
Perhaps more important than the near-term return benefits is the injection into the lending market of some degree of excitement and competition, however small, that has been noticeably absent since the late 1990s. The question on the minds of equity sponsors must be whether this is a temporary foray into the market for the new senior lenders or a permanent shift in the lending market.
While emerging senior lenders have been very active, most people agree that the senior debt market is competitive and that no group will have a clear long-term advantage over others. While many asset-based and emerging cash flow lenders are not regulated to the same extent as commercial banks, the structuring and pricing latitude that independent lenders have is limited by the need to syndicate deals and compete with numerous non-regulated and regulated lenders.
Asset-based and sponsor-focused lenders are, however, split on what will happen when cash flow lending from commercial banks returns. Some market participants believe that asset-based and sponsor-focused lenders will be the first to feel the pinch when cash flow products return to the market and competition increases for the senior tranche.
The interest rate environment also certainly will help determine who prevails. In today’s low rate environment, asset-based and some sponsor-focused cash flow lenders, who are pricing on a spread (typically to LIBOR), have a clear edge over risk-based lenders. In a rising rate environment, we expect the risk-based lenders’ rates will be less elastic and may even become the more attractive source of capital.
The ultimate market dynamics cannot be determined, but what is clear is that even as some lenders are carving a new niche for themselves, the higher priced risk-based lenders continue to expand a market that has seen increasing levels of activity for a number of years. These lenders feel they have carved a niche for themselves and will continue to remain active as an alternative to, or as an addition to, cash flow lenders.
ABL stretch lending and sponsor-focused cash flow lending portend not only higher returns on completed deals, but also the ability to carry more deals across the finish line. With more room for equity returns, the number of deals that meet return hurdles and the number of sellers with realized price expectations are sure to increase. While the market as a whole has been slow to provide corporate credit, asset-based lenders and new sponsor-focused entrants-perhaps less hampered by their past-have begun to test the market with products that look more like the multi-tranched senior debt deals that fueled the LBO boom of the 1990s. It remains to be seen how much of a boost these lenders will give to the still reeling (albeit moderately improving) M&A market or who ultimately will be the prevailing provider of the senior tranches of the capital structure commercial cash flow lenders, ABL and sponsor-focused lenders or the risk-based lenders. We are fairly certain, however, that in our market economy, a little competition from lenders and more available capital can only be good for private equity investors.
Mike McGill is a managing director, and Eric Wenick is a principal, at Dallas-based MHT Partners. MHT Partners is an investment bank providing M&A and debt and equity private placement advisory services to emerging growth and middle market companies. During their careers, the professionals at MHT Partners have executed M&A and advisory deals totaling more than $15 billion of enterprise value and raised over $7 billion of public and private debt and equity securities.