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Observations on the state of middle-market lending, June 2010

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On June 9th, my partners and I met with more than twenty private equity firms at the ACG Boston Dealsource event. The program gave us a unique opportunity to talk in depth about the leveraged buy-outs that are getting done, the debt financing available for these transactions, and the impact of liquidity – or a lack thereof, on financial sponsors.

A few key take-aways:

  1. The cost of financial leverage (i.e. the debt used to finance leveraged buy-outs) is high, and the availability is low, but getting better, as several finance companies have recently raised new capital and new non-bank lenders are coming online;
  2. Every large national bank, and most smaller and regional banks have narrowed their focus since early 2008. They are lending in fewer industries, backing fewer small companies, and focusing more on the borrower’s balance sheet (specifically collateral) and less on the income statement;
  3. Asset-based lending (ABL) has once again become the primary bank-offered solution for borrowers to stretch their balance sheets. True cash flow lending has largely disappeared from the vocabulary of bank underwriters, and is only available (at higher interest rates) from a handful of non-bank lenders, including finance companies, hedge funds and mezzanine lenders;
  4. Dan Corcoran at US Bank tells me that borrowers with strong performance and a good operating history can expect a mix of “middle-market” and ABL deal terms, which is an improvement to what was “market” just 3-6 months back.
  5. Ironically, lenders see the current market as a “borrower’s market” – with lower rates and a general easing of covenants. The reason is that most banks are writing fewer loans, and all lenders are now offering essentially the same ABL solution. Since every bank is chasing the same handful of deals that fit their more narrow parameters, it stands to reason that there is significant competition among banks to underwrite those few loans. Therefore, compared to 2009, rates are lower, and covenants are slightly less onerous – if you are lucky enough to get a loan.

Based on the new reality, some private equity firms are changing their strategy. A few themes emerged as the day progressed: 

a. In mid-2007 a bank would lend 4x EBITDA on a lower-middle-market LBO, and would allow the buyer to use 5x or 6x total leverage. That amount of leverage is now only available for deals where the borrower has in excess of $10 million of EBITDA;

b. Today, a bank will only lend 2.5x EBITDA – if the collateral is sufficient – on a sub-$10 million EBITDA deal, with no more than 4x total leverage. Some non-bank lenders will offer a unitranche or structured deal (at higher interest rates), but getting beyond 4x total leverage for a borrower with $5 million EBITDA is unlikely.

c. The roll-up model of the past decade was an arbitrage play: buy companies at 5x-6x EBITDA, put them together using significant financial leverage, then sell at 8x EBITDA or more.

d. Leverage drives value. If a financial sponsor cannot get adequate leverage, then they cannot finance a transaction if the bidding gets comptetitive (i.e. they cannot afford to pay a multiple in excess of 6x earnings, as it would result in a lower internal rate of return);

e. Some firms, like Summit Partners in Boston, have moved even further “up market”, focusing more on deals with $10M EBITDA and up, because smaller deals don’t allow them to get the leverage they need to pay a competitive price.

f. Because LBOs cannot compete on valuation for middle-market deals, some buy-out groups are shifting their model from the roll-up (or “growth by acquisition”) model of the last decade, to a debt repayment model. Their focus is to buy a profitable business – perhaps in an out-of-favor industry, leverage it up to whatever degree they can, and focus on maximizing earnings in order to repay the debt and extract dividends. The new model has less upside, but it is far less risky, with very little downside.

g. Private-Equity Firms are increasingly getting into the lending business. They are stepping into the void left by banks, and they are providing the leverage needed to fund buy-outs. Examples include Deerpath Capital, Highpoint, and Peninsula Capital.