Monday, October 14, 2013

Leveraged Acquisition Loans: Fasten Your Seatbelts

The leveraged acquisition (non investment grade) market is heating up again. It is being driven by loan investors, both bank and non bank CLOs (Collaterized Loan Obligation funds). The investors are chasing yield in a low rate environment in which the forward calendar of new transactions remains tight. The low rates increase the affordability of higher debt levels by moderating debt service requirements. The rates are usually locked-in on a substantial portion of the debt through fixed rate bonds and interest rate swaps.

Deal structures follow market movements. Note the following (Source S&P Capital IQ):

Funded Debt/EBITDA (FD/EBITDA) up from the 2009 low of 4X to 5.5X, but still below the 6.2X 2007 peak.

Equity % contribution down from the 2009 high of 45% to 30%, which matches the 2007 peak.

The more aggressive capital structures improve the affordability of private equity sponsor based acquisitions. This is usually translated into higher purchase multiples as will now be illustrated:

1)   Assume the target has $100 EBITDA. A 4.5X FD/EDITDA multiple combined with a 30% equity contribution can support a $640 price or a 6.4X purchase price multiple (PPX).

2)    An increase in the debt multiple to 5.5X with the same equity contribution can support a $780 transaction with a 7.8X purchase price multiple.

This fact is reflected in the recent increase in PPX from 7.7X 2007 lows to current 8.5X levels. This is still, however, below the 2008 9.7 PPX peak.

These facts have not gone unnoticed by banking regulators. A recent Shared National Credit (SNC) report authored by the Federal Reserve, FDIC and OCC highlighted the widespread weakness in large syndicated leveraged loans exceeding $20Mln shared by three or more institutions. They especially noted:

1)     Excessive leverage
2)     Inability to amortize debt
3)     Weak covenants
4)     Minimal equity

This will have a significant impact on the bank loan syndication market.

Markets can be fickle. Just because you can do something does not mean you should. Acquisitions based on cheap plentiful credit frequently end up badly. The results of the class of 2007 private equity funds and transactions are evidence of this fact.


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