Listening to Markets and Hearing Government

Readers of this blog know that Joe and I are strong advocates of listening to the market - being aware of current conditions and opportunities.  Certainly, in structuring a deal we must contend with economic reality; a situation suitable under one set of economic conditions may be far from optimal in another.

Many analogies and cliches apply - e.g., play the cards you are dealt.  The best quarterbacks in American football learn to read the defenses and take the best opportunities.  So too should we read the market and find the best solutions.

In the best of situations, markets reflect the economic equilibria of competitive forces.  But alas, they also reflect governmental restraints.  The Wall Street Journal recently published a very interesting article showing the impact of government activity on deal flow.  The article, entitled, "Buyout Firms Feel Pinch From Lending Crackdown" suggests that regulatory guidelines favored by the government are impeding deal activity and deal design.  In particular, the author notes that regulators urged banks to avoid putting debt greater than 6 X EBITDA in most industries.  Further, "So far this year, 21% of U.S. private-equity deals have been financed with leverage at or above levels regulators generally consider risky..." down from 35% last year.  The chart below (from the WSJ article) captures some of these dynamics.

The merits of this regulatory guidance is a subject for another debate, although regular readers can guess where our feelings lie on the subjects of free markets, free choice and the law of unintended consequences.  To be fair, Joe and I have both warned of the dangers of highly leveraged deals and over-excited markets, but we prefer to take things on their merits and consider things in context to all of the other factors that go into structuring the deal.  One size rarely fits all.    But like it or not, the regulators are part of the world we mentioned and hence, their impact must be factored into our decisions.

All the best,

Ralph

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.

J