The current year in M&A is approaching its midpoint and several financing trends are beginning to emerge. Mid-market companies and private equity (PE) funds continue to respond to the regulatory rules aimed at banking institutions and the limited ability of these institutions to finance deals. Since 2009, the Dodd-Frank Act created provisions that more strictly regulated the securitization market, and provisions under Basel III, which will be implemented through 2018, increases banks’ capital and liquidity requirements.
Over the last 20 years, the market share of leveraged loans for banks and security firms has declined dramatically and it is expected that new regulations will further inhibit bank participation in both the bond and loan markets. According to a recent KPMG LLP survey of 200 mid-market executives, more than 50% indicated that increases in bank regulations would have an impact on their banking relationships. When asked what methods businesses would use to obtain capital in 2014, only 26% of survey respondents said that companies would seek a bank loan to refinance on more favorable terms.
While banks might be lending less, other alternative entities are lending more. These alternative sources of capital include hedge funds, business development companies (BDCs), credit opportunity funds, and the resurgence of collateralized loan obligations (CLOs). The good news for borrowers is that these alternative sources of capital frequently provide more beneficial and tailored deal terms.
Creative Structures Abound
This year the economy in general, and the capital markets in particular, have gained strength. Perhaps the most obvious outcome has been the incredible success of the initial public offering (IPO) market, which is at its most active since 2006. The increasingly robust economy, combined with the proliferation of capital as new investors enter the U.S. capital markets, has resulted in a competitive environment for lenders.
Alternative lenders have become more aggressive and are offering flexible and creative financing solutions, including unitranche facilities, term A and term B and mezzanine loan structures, light amortizations, convertible preferred and holding-company loans. Although these more generous terms are often accompanied by a higher cost of capital, companies often believe that the benefits outweigh any added costs.
These “covenant-lite” deals, often paired with working capital facilities, now represent over 50% of the new-issue, leveraged loan market;1 traditionally, such deals have been isolated to the larger market, but the mid-market could soon benefit if the overall credit market remains aggressive and investors continue to chase yield down market.
Issuers are also finding the market is receptive to asset-based lending (ABL) facilities that incorporate “springing” covenant coverage ratios that activate when certain thresholds are reached. The unitranche facility, which includes the combination of senior and junior credit risk into a single security, is very prevalent — especially in mid-market leveraged buyouts (LBOs). Therefore, companies seeking capital may find that they are more easily able to put together an individualized financing package that addresses their specific needs.
Key Issues to Consider
While there may be an abundance of alternative institutions eager to supply capital and the market may be receptive to creative structures, deal-makers still need to be aware of several issues as they analyze their financing options. Over one third of KPMG survey respondents said that they expected corporate M&A to drive the credit markets; 26% said the market would be driven by refinancing and 23% by PE buyouts. However, corporate deal-making is not as active as many had predicted, even with favorable market conditions and cash-heavy balance sheets.
That lack of activity has translated into more capital-chasing, opportunistic deals, such as repricings and dividend recapitalizations. As previously highlighted, alternate sources of capital are becoming much more prevalent, especially for mid-market deals, and companies seeking to access the credit markets are finding that the interest rate spreads are tighter, there are more aggressive structures being instituted and there is an increase in flexibility surrounding inter-creditor issues when both senior debt and junior debt are included.
It is important for management to analyze what their real financing needs will be beyond the transaction itself. Even in today’s very receptive market, companies should remain cautious and stay focused on their long-term financing business goals, in addition to looking at short-term needs. Essentially, companies should find the right financial partner not just for its immediate needs, but also, and more importantly, to support their ongoing growth initiatives. With so many financing options available in such a robust market, companies should contemplate running a competitive process to find that “partner.” A well-thought out business strategy must be a key part of any financing decision.
Contrary to the increased demand for deals and the prevalence of more aggressive structures, it’s evident that lenders are being increasingly diligent in both their screening of new deals and in their underwriting process. Therefore, the typical timeline may be extended, and many mid-market deals are usually taking three to four months to close. Companies should be prepared for this approximate timeline, but also do everything in their power to simplify the process by having all required documentation organized and ready in advance of the transaction start date.
The Market is Your Friend
Acquirers pursuing deals in the immediate future are likely to find themselves in the enviable position of approaching a very favorable market. It is certainly a buyer’s market, and companies should push for more favorable terms than those available just a short while ago. Issuers should not only seek to have their financing partner favorably support M&A activity, but also for dividend recaps; and more and more companies are taking advantage of today’s environment to refinance debt that matures as far out as 2016.
Possible Uncertainty Ahead
As we have seen in the last few years, the capital markets can change rapidly in response to numerous political and economic factors. According to KPMG survey respondents, the greatest risk to the credit environment will be a potential bubble created by the demand for yield (29%). Other risk factors include inflation (23%); geopolitical stability (22%); and loosening of credit standards (10%). When asked what will most affect the leveraged loan market this year, rising rates topped the list (35%). Additional factors include the continued proliferation of new capital sources providing more options and flexibility (20%); loan issuance in connection with M&A (18%); and capital providers further driving yields lower (15%). Companies interested in accessing the credit markets should be aware of these possibilities as they plan their financing strategy.
Additionally, at of the close of the first quarter in 2014, global and U.S. M&A volumes were down compared to the same period in the previous year. However, analysts expect a brisk market for M&A deals in the coming months amid an improving environment for financing and a desire on the part of well-capitalized companies to strengthen their operations through buyouts. This is supported by a string of global mega-deals announced in the first quarter, with eight super-sized transactions worth $166.3 billion2 in total.
As this year is reaching its mid-point, market fundamentals remain favorable and liquidity continues to flow in. We expect the credit markets to remain very active and supportive of both M&A and opportunistic deals. Those seeking financing will find that alternative sources of capital have replaced any diminishing activity by banks becoming overburdened by regulations. Those seeking capital should use the market to their advantage, while at the same time focusing on selecting the right, strategic financial partner that will best support their long-term financing needs.
Ray Kane, co-head for Capital Advisory, KPMG Corporate Finance LLC, has more than 20 years of experience with the origination and sale of securities to investors in the private placement market. Transactions include a wide variety of structures involving mezzanine financings, second lien notes, last out participation securities, B loans, ABL facilities, structured equity and growth equity, as well as non-investment grade and investment grade debt placements.
Joe Rodgers, co-head for Capital Advisory, KPMG Corporate Finance LLC, has more than 20 years of professional experience through a unique combination of finance, investment banking, advisory, and turnaround projects. His focus is on providing value to public and private clients in three areas: capital structure advisory, debt restructurings and capital raises of existing debt, new debt, junior capital or equity.
About KPMG’s Credit Markets Survey
KPMG LLP held the Semi-Annual Credit Markets Webcast in December 2013 and polled more than 200 mid-market financial executives, investors and professional advisors from companies with revenue under $1.499 billion in an effort to gauge market sentiment for the first half of 2014. A replay of the webcast and be found by visiting KPMG Institutes at: http://www.kpmginstitutes.com/global-enterprise-institute/events/pmg-webcast-navigating-the-current-credit-markets.aspx.