One of our favorite private equity firms just completed a financing. After talking to a bunch of lenders and after much negotiation, they closed on a $110.0 million unitranche loan with total funded debt of 5.5x EBITDA at the incredibly low rate of LIBOR + 800 basis points with a 100 bp LIBOR floor.
The borrower was giddy with excitement at the low interest rate, but, perhaps tellingly, so was the lender. Because, interestingly, while the borrower thought he just landed a loan with a 9.0 percent interest rate, the lender was studying the LIBOR forward yield curve and believed their new loan was going to yield substantially more than that. In fact, if the forward LIBOR curve is to be believed, the yield on the loan in five years will be nearly 11.5 percent, a 25 percent increase, with the average annual yield over this five-year period expected to be approximately 10 percent!!
We have gone through a very long period of extremely low interest rates which have made debt capital not only plentiful but incredibly cheap. And it is an almost universally accepted fact that this low interest rate environment will, at some point, have to end.
Pundits debate when this will be, but when it does, everyone knows that rates will increase. But what will be the impact on the many companies that have stretched leverage over the past few years to take advantage of the market’s favorable liquidity conditions through the use of large floating rate loans?
Without getting too quantitative, it might be useful to look at fixed charge coverage levels. Remember that $110.0 million loan that just closed? With EBITDA at $20.0 million, capital expenditures of only $3.0 million per year, and amortization a mere 2.5 percent annually, the borrower’s fixed charge coverage rate (FCCR) at close was just under 1.20x. Now fast forward five years, when the LIBOR yield curve indicates that LIBOR will be approaching 3.5 percent.
Assuming no growth in the borrower’s EBITDA but also no increase in amortization, the FCCR declines to a meager 1.0x. Not only is this likely to hamper management’s ability to operate the company, but unexpected hiccups in the borrowers performance could easily create significant cash flow issues for the company and trigger a default. Clearly, companies that meet their growth forecasts will avoid these issues.
Once upon a time, both lenders and borrowers furiously worked and reworked their Excel spreadsheets to factor in all sorts of sensitivities such as revenue declines, changes in material prices, etc. But how often is the sensitivity that looms largest today – higher interest rates – factored in to models? Borrowers thought they were big winners when lenders reduced their LIBOR floors from 150 bp not that long ago to today’s 100 bp prevailing standard. While borrowers picked up some initial advantages from that change, this may be offset when LIBOR is projected to exceed 100 bp in about two years. From there on out, the floor is irrelevant, and borrowers may be paying much higher interest rates than they were anticipating.
Interestingly, most lenders that are required to mark to market their portfolios actually take in to account the projected increases in LIBOR when valuing their loans. Many lenders use the forward curve to determine the interest they will receive over the life of the loan before discounting these cash flows to determine fair value. These lenders are fully aware of the value of their floating-rate loans and often tout the advantages in their public filings and analyst calls.
So next time you look at a lender’s term sheet and see that the LIBOR floor is only 100 bp, it might be wise to think about what the lender knows that you may not.
Ron Kahn is a managing director at Chicago investment bank Lincoln International