Senior Debt Returns To Market Hungry To Do Deals

Senior loan issuance backing mid-market LBOs in the fourth quarter of 2009 hit $6.4 billion, the highest quarterly total since the third quarter of 2008. Indeed, fourth quarter issuance for such mid-market buyouts—defined here as deals where enterprise value and issuer revenue are both below $500 million—rose 130 percent and 170 percent, respectively, when compared to the third quarter of 2009 and the fourth quarter of 2008, according to Thomson Reuters LPC (see related table).

Two big factors in the leveraged lending market’s rebound have been an economy on the mend and a secondary loan market where bids are coming in north of 90 percent of par, which has investors looking to new issuances for higher yields. “The knife has quit falling, and people finally know what they have in their portfolios,” said Brian Crabb, a managing director at Fifth Third Sponsor Leveraged Finance, the new sponsor-focused lending arm of Fifth Third Bank, which provides senior cash flow loans of $30 million to $150 million to companies with EBITDA of $10 million to $40 million. “While I’d certainly have a hard time calling the senior lending market robust at this time, there does appear to be a critical mass of lenders that have either entered or reentered the market, which is certainly a healthy thing,” Crabb said.

The relief would be long in coming. The loan market’s collapse in the summer of 2007 led to two key obstacles in the senior lending market that choked off the flow of capital through much of 2009. Many lenders took to the sidelines to triage ailing portfolios or to invest exclusively in the secondary loan market, where some paper was trading at discounts of up to 50 percent of par. Concurrently, company performance tanked indiscriminately across much of the economy to the point that the few lenders still willing to make new loans could no longer get comfortable with future earnings predictions. Not knowing how far earnings would fall, lenders were not willing throw money into a bottomless pit.

Now, the slow build-up in senior lending capacity levels promises to provide the spark that ultimately ignites LBO deal volume back to historic levels. That said, the sparsely populated lower end of the middle market may be left out of the party, while the buyout market that emerges from last year’s ashes will likely have some key differences compared to its former incarnation. Higher equity contributions, for one, will translate into lower return expectations, a factor that could push buyout shops to focus more of their attention on high-growth companies or industries than they had in the past.

Growing Capacity

Fifth Third Sponsor Leveraged Finance is one of several new senior lenders that opened their doors late last year with the goal of hitting the market full-speed in 2010. New York-based Amalgamated Capital was launched in September by Amalgamated Bank to provide senior cash flow loans of $5 million to $60 million to lower-mid-market companies with EBITDA of $3 million to $15 million, while in November, Peter White, formerly of CIT Group Inc., joined TD Bank to establish a sponsor finance group to back LBOs along the eastern United States from Maine to Florida.

Other mid-market lenders are also gearing up. New York’s Golub Capital plans to deploy $1 billion in mid-market debt financing in 2010. It filed to form a business development company (BDC) late last year, which, according to a public filing, would generate even more capital for the firm to deploy. Chicago’s Monroe Capital, meanwhile, is in the market to raise $500 million in new capital to deploy in mid-market loans, while Boston’s NewStar Financial announced in January that it raised a new CLO giving it $50 million in new lending capacity. In 2009, NewStar Financial completed about a dozen new mid-market financings, and the firm expects to more than double that level of activity in 2010 (see related table for details.)

The build-up in senior lending capacity at a time when overall deal flow remains slow can only mean good things for a buyout community that’s been paying historically high prices for debt since the debt markets collapsed in mid-2007. “Spreads are narrowing and part of the reason for the contraction is that there’s so little [deal] volume out there,” said Tim Conway, CEO of NewStar Financial. “When a deal does come to market, there are a lot of lenders out there with excess capacity that want to compete for it.”

In early 2009, average pricing on senior cash flow loans generally was LIBOR + 700 bps, with a LIBOR floor of about 300 bps to 350 bps. Today, middle of the road pricing is about LIBOR + 550 bps with a LIBOR floor of about 200 basis points, according to data from mid-market investment bank Lincoln International.

At the same time, lenders are also willing to increase the amount of capital they deploy on a per-deal basis. In the first half of 2009, senior leverage multiples for credit-worthy companies tended to max out at just 2x EBITDA, while total leverage generally hit EBITDA multiples of 2.5x to 3x. More recent credit-worthy deals, however, have been able to garner senior leverage of about 3x EBITDA and total leverage of 4x EBITDA or more.

“That’s a huge swing,” said Ronald Kahn, a managing director at Lincoln International and head of the firm’s debt advisory group. “A one-turn increase in leverage multiples and a pricing decrease of about 200 basis points all in about six months is pretty dramatic.”

While these are rough figures, several recent deals illustrate this improving paradigm (see related table). With the help of lead lenders Bank of Ireland and GE Capital, Odyssey Investment Partners was able to secure senior leverage of 3x EBITDA and total leverage of 4.25x EBITDA for its December acquisition of diagnostic imaging provider One Call Medical Inc. Pricing on the senior portion of the deal included a LIBOR floor of 200 bps and a total margin of LIBOR + 575 bps, according to Thomson Reuters LPC.

A little further up market, General Atlantic LLC and Kohlberg Kravis Roberts & Co. (for their December acquisition of Northrop Grumman’s Tasc consulting unit) secured senior leverage to the tune of 3.8x EBITDA with pricing at LIBOR + 350 bps and LIBOR + 375 bps for the deal’s Term Loan A and Term Loan B, respectively. Total leverage for the deal hit 5.8x EBITDA. Lead lenders for the $1.65 billion carve-out included Barclays Capital, CPPIB Credit Investments, Deutsche Bank and RBC Capital Markets, according to Thomson Reuters LPC.

Whether reduced pricing and increased leverage in the middle market will extend to smaller deals for issuers with EBITDA of less than $10 million remains to be seen. Deals in that category tend to be seen as riskier, and there are fewer lenders willing to accommodate them. “Not many lenders operate below the $10 million [EBITDA] threshold, and as a result of that we haven’t seen as much pressure in both price and leverage, in part because you’ve got less competition at that level,” said Timothy Clifford, head of Amalgamated Capital and Executive Vice President of Amalgamated Bank.

Clifford noted that senior cash flow loans in the lower end of the middle market still command average pricing of LIBOR + 650 bps and hit typical multiples of about 2x to 2.5x EBITDA. Total leverage tends to cap out at 3x to 3.25x EBITDA, Clifford said.

It’s also not likely that the widening availability of leveraged loans will put an end to the upsized equity contributions that have become the norm since late 2008. Market-wide in 2009, the average U.S. LBO included 46 percent equity in its capital structure, according to Standard & Poor’s Leveraged Commentary & Data. That’s well above the 32 percent average equity contribution that shaped the market in the five-year period ended Dec. 31, 2007.

When Berkshire Partners LLC acquired Grocery Outlet Inc. in the fourth quarter of 2009, the Boston-based firm’s equity contribution accounted for approximately 50 percent of the deal’s total value. Senior debt for the deal, including a $25 million revolving credit line, came in at 3x the discounted grocery retailer’s EBITDA of $60 million, according to Thomson Reuters LPC.

“Forty percent equity is the minimum today,” said Lincoln International’s Kahn. “Even if you’re buying a company at 7x [EBITDA], which is a pretty good multiple, you need 40 percent equity.”

Lawrence Golub, president of Golub Capital, called LBOs with a total valuation of about 8x EBITDA “a pretty good median” for mid-market deals today.

With transactions commanding these high multiples and sponsors expected to shoulder more of the burden themselves, “growth has become a very large part of almost every buyer’s investment thesis,” Golub added. Of course, the definition of growth in today’s market has changed. Growth today could simply mean a natural recovery from the recession. “There are a lot of companies whose profits used to be a lot higher than they are now,” Golub said.