Private Eye: Creditors see yellow lights flashing in middle market

“It’s starting to feel like there are more and more cracks starting to appear in our market,” said Justin Kaplan, partner at Balance Point Capital, speaking on a leveraged-loan panel last month at Buyouts Insider’s PartnerConnect Texas conference in Dallas.

Kaplan and fellow panelists — Jason Safran, senior asset manager at Texas Christian University Endowment, Stefan Shaffer, a founder and managing partner at SPP Capital Partners, and Christine Tiseo, a managing director in the debt advisory unit at Lincoln International — pointed to several troubling developments of late.

These include a rise in credit deterioration of mid-market companies; a jump in the number of hung deals in the larger, more liquid end of the leveraged-loan market; and the aggressive use of EBITDA adjustments by borrowers.

“I think we’re in the final stages of a credit bubble,” said Shaffer, whose firm helps raise debt financing for mid-market clients and also lends directly itself through specialized funds.

To be sure, the leveraged-loan markets have had a good run. Describing himself as the “allocator” on the panel, Safran said that when he joined six years ago, investment-grade fixed-income products dominated the absolute return portfolio of the $1.7 billion Texas Christian University Endowment. Today, he said, the portfolio is made up primarily of managers of cash-flow generating private equity-style strategies of which private lending is probably the biggest part.

Safran praised such managers for employing European-style distribution waterfalls and hurdles, ensuring that investors generate their expected returns before the fund manager receives its profit share.

He said the best managers in the market do more than just provide capital; they bring industry expertise to the table, or the ability to solve complex problems. On the downside, the endowment has to deal with greater illiquidity in the private markets, whereby assets aren’t as easy to buy and sell. “But,” Safran added, “we’re getting compensated for it.”

All that said, Safran said he’s keeping an eye on increasingly aggressive EBITDA adjustments produced by companies to help justify higher purchase prices and higher levels of leverage. The endowment, he said, monitors “true leverage” and how that borrowing would affect credit losses should borrowers run into trouble. The private lending markets have been “very good” over the past five to 10 years, Safran added, but hasn’t been hit with a “true test.”

Indeed, Safran’s fellow panelists see troubling signs that a true test could be coming.

  • Shaffer, whose firm helps arrange debt financings of $15 million to $200 million, describes market conditions as “the most liquid environment” he’s ever seen. That’s led to debt pricing getting cheaper and leverage metrics getting “pushed out,” as EBITDA multiples rise from the 4x range to 4.5x to 5x and on to 5.5x.
  • Kaplan, whose firm occupies the lower-middle market, said Balance Point Capital tracks the performance of companies in the portfolios of business development companies. The level of credit deterioration among those portfolios is the highest it’s been since 2007, he said.
  • Once they’ve delevered a company to, say, 2.5x EBITDA, many sponsors come to Balance Point Capital to borrow money to finance a dividend — a sign of a frothy market. Ten years ago, “that concept didn’t exist,” said Kaplan.
  • With sources of credit abundant, sponsors have also been able to negotiate better terms. Where deals once might have had 10 financial covenants, today they might only have two or three, said Kaplan. With fewer covenants, creditors have less leverage to influence the direction of a company whose performance has soured. They also may find out about poor performance later than they would have in the past.

Panelists also agreed that companies are pushing the envelope when it comes to making EBITDA adjustments in their financial statements. No one has a problem with customary adjustments for one-time expenses such as severance payments for laid-off workers. But using run-rate extrapolations, companies may adjust full-year EBITDA to account for a price increase that took place in the middle of the year — or to account for landing a big new account mid-year. “Those are the ones that are a little bit more squishy,” said Lincoln International’s Tiseo, especially when the company cherry-picks positive events for adjustments.

The problem isn’t necessarily that anyone gets fooled by the adjusted EBITDA figures. But they do reflect real risks that both buyers and creditors are taking. Buyers have to pay off debt with actual cash flow, a task that could get more difficult in a recession if the adjustments turn out to have been illusory.

According to Tiseo, an internal study by Lincoln International of 1,400 mid-market businesses found that adjustments averaged 30 percent of total reported adjusted EBITDA. Do the math and that means that sponsors paying 9x adjusted EBITDA for a company are actually paying 12x EBITDA minus the adjustments.

In a downturn, Tiseo said, some of those adjustments could “quickly evaporate and create some very distressed businesses.”

She added: “You can’t service debt with EBITDA add-backs.”

Action Item: Listen to a recent Lincoln International Webcast on the state of the debt markets at