The Changing Investor Menus of Acquisition Finance

Low interest rates have encouraged investors to increase their risk appetite in search of yield. Issuers and arrangers have accommodated them with aggressive deals and financing structures; thereby supporting growing M&A volume. These usually work out until something happens. The August correction is one of those things. Investors, post correction, have paused to reassess their marked down portfolios, and have reduced their risk appetites. This presents problems for unfunded deals structured in the pre correction 1H15, but are only now coming to investors for financing. We previously examined this problem in 2013 with Rue21 in which the loan underwriters incurred large losses.

A current example of the same problem is FULLBEAUTY BRANDS (Beauty). Beauty is an on-line plus sized clothing retailer owned by PE firms Charles and Webster Capital since 2013. In March this year Beauty levered up to pay its owners $215 Mln via a special dividend, and announced plans for a summer $250 Mln IPO. The IPO window was wide open at that time. It subsequently closed late summer resulting in its owners switching to plan B-the sale of the firm. Apax, the same PE firm as in Rue21, agreed to acquire (secondary buyout) Beauty for undisclosed amount funded in part by $1.650B in loans underwritten by JP Morgan Chase, Goldman, Jefferies, and Deutsche.  JP Morgan Chase and Jefferies were also involved in Rue21.

Some details are as follows:

1)     Loan Facilities:

$820 Mln First Lien Term Loan -7 year term at LIBOR+450 BPS

$345 Mln Second Lien Term Loan -8 year term at LIBOR+850 BPS

2)     Leverage

First Lien-4.7X EBITDA

Second Lien (total)-6.7X

3)     Rating “B-“

The loan underwriters are experiencing sluggish demand for the loans based on several factors. First, increased concern over a slowing economy is dragging down retailer prospects. Next, the deal is highly levered at 6.7X, which exceeds bank regulatory guidelines and reduces the potential investor base. Non bank loan investors (CLOs) usually fill the gap, but have suffered portfolio losses during the summer correction. They are becoming more credit quality sensitive-especially toward higher risk second lien loans.

The Beauty loan syndication is still a work in process. The underwriters’ options, absent a rebound in investor risk appetite, are somewhat limited. Attempts to increase loan pricing or reduce leverage are unlikely to be received well by Apax, absent bear market pricing or structural flex provisions. More likely, they will be forced to offer deeper discounts at their expense (loss) and hold larger than planned portions on the loans.

Like war, most of the time acquisition finance is calm and boring. It is, however punctuated by brief moments of terror when investors risk preferences changes.

J

Rue21: A Deal to Rue

Yield hungry investors have swarmed syndicated leveraged loans this year. It seemed that they were throwing caution to the wind. Anything and everything seemed possible. Then came Rue21-one of the biggest high profile deals to flop in a while. Rue is a rapidly growing value orientated teen apparel fashion retailer. It has added 500 stores over the past years, and is scheduled to reach 1000 stores by year end.

In May, Apax, a UK private equity firm, offered to buy Rue for $1.1B Acquisition with a $62 Mln breakup fee. An affiliated Apax entity already owned 30% of Rue. The offer represented $42 per share- a 23% premium to market, 1.2X sales and 9.2X EBITDA. Comparable multiples were 0.5X sales and 8.4X EBITDA. The premium represented Rue’s rapid growth potential.

Apax would contribute $280 Mln in equity with the balance financed by debt representing a FD/EBITDA multiple over 6X. The debt included a JPMChase, BofA and Goldman $530 Mln syndicated loan. The loan was richly priced at L+ 475 with a 1% LIBOR floor.  During the syndication, Rue announced disappointing sales and earnings due to a “challenging retail environment”. Same store sales fell 9.5% thru 3Q and by 12.8% in September. The syndication struggled, and the agents offered 20-25% discounts without success.  See Syndication.

Some observations:

1)  Aggressive leverage for a rapidly growing firm is always a challenge. Add in fashion retail and the margin for error is razor thin.

2)  The purchase price was rich leading to the need for increased leverage. It only made sense assuming Rue’s growth would continue.

3)  Unexpected performance issues during the syndication are always possible. Nonetheless, I wonder how unexpected this really was. First, simple extrapolation, which appears to be the case here, is dangerous when constructing projections for growth firms. A modest downside case would indicate how problematic the debt service would be if a slowdown occurred.

4)  Basic earnings quality analysis also suggested concern. Earnings are an opinion while cash is a fact. Despite Rue’s growing sales and net income since 2009, their free cash flow peaked in 2011, and fell in FYs 2011 and 2012.  Growth related, rapid CAPEX and inventory increases were part of the problem. This coupled with a performance decline suggests a) Rue must curtail its growth and b) Rue will have difficult time repaying its debt. Loan investors undoubtedly saw this, and declined to participate despite the original rich price and even with the substantial discount -  they would not bite.

Diminished growth means the purchase price and capitalization rationales are no longer valid. Apax should consider renegotiating the deal or walking away after paying the breakup fee. The banks would be happy. Rue’s current shareholders, of course, would be upset, but would still be $62 Mln richer. Discretion is sometimes the better part of valor.

J

PS - Just over two months until Acquisition Finance in Amsterdam (see side note or click here)