With the overall economy improving, recent approaches to asset-based lending (ABL) will not deliver the amount of debt capital necessary to serve the re-emerging middle-market and lower middle-market merger and acquisition marketplace.
Many businesses in this sector have been able to demonstrate consistent trends of revenue growth throughout 2010. Since these same companies dramatically reduced costs during the downturn, many are now experiencing unprecedented and growing EBITDA margins. The pent up acquisition demand of private equity funds is being manifested in real competition for these quality businesses whose owners are anxious for an exit. As a result, the purchase prices for these sorts of businesses are rapidly escalating. The limitations of secured financing will be tested to meet the newly emerging pricing paradigm. Private equity funds will be demanding creativity and significant stretches from their lenders.
ABL: Here Today, Gone Tomorrow?
Asset-based debt financing is very hot today, but some of us wonder how long it will last. “Asset-based lenders are very active getting deals done right now! ABL structures are simply the better alternative today while the credit posture of cash-flow-based lenders remains relatively tight,” said Douglas Kelley, principal of sponsor finance for American Capital. A secured loan is certainly the most attractively priced debt today, but, practically speaking, it is also the only senior debt available for lower middle-market businesses.
While cash-flow lending was adopted by banks of all shapes and sizes through mid-2008, few institutions had the intestinal fortitude, credit committee cooperation and balance sheet to keep it up during 2009 and 2010. Even fewer are proposing senior cash-flow term sheets for transactions, especially deals involving companies with EBITDA below $15 million.
During the darkest days of 2008 and 2009, banks routinely “converted” cash-flow credits to asset covered credits. The conversion often included some fees, certainly some new covenants and more stringent advance rates and controls appropriate for ABL structures. Upon notification of conversion, businesses would often shop their banking relationship only to find similar treatment at other institutions.
Now though, lenders are spreading their wings again, driven by competition. With competition and pressure from private equity funds, cash-flow lending will have a near-term revival.
The Re-Emergence of Cash-Flow Lending
The question is not whether cash-flow lending will emerge, but rather when it will. The transactions and financing markets are inherently cyclical. Of course, there will always be a handful of asset intensive, volatile or cyclical businesses that keep the lights on for ABL shops, even during peak economic times.
Few experts want to definitively weigh in on the timing of this transition to cash-flow financing, but most believe that the go-go days of the pre-global downturn air ball will soon be upon us again. If the economy continues to grow, even anemically, and does not recess again, lenders will drive competition and we will see a return to cash-flow lending. “When the economy ‘recovers’ and senior lenders want to grow loan portfolios, you will see competition drive leverage multiples for lower middle-market companies (EBITDA between $5 million and $20 million) to peak levels again, and the cycles will continue,” said Kelley of American Capital.
With ABL King, Mezzanine Financing Must be Queen
Of course, ABL structures depend on adequate quality collateral. When the collateral does not support a figure needed by the business to operate effectively and grow, mezzanine lenders will fill the void. Mark Champion, managing director of loan originations for Wells Fargo Capital Finance, pointed out, “The second lien and mezzanine crowd has returned to the market and is eager to put money to work in the current environment. They are achieving solid returns at a reasonable leverage point.”
Given that most middle-market senior lenders are lending up to two turns of EBITDA or a bit more in certain situations, mezzanine lenders today are covering the third turn, plus or minus. As recently as 2008, mezzanine lenders were covering the fifth or sixth turn of EBITDA, a remarkably different position within the capital structure. With competition among mezzanine lenders, pricing pressures are beginning to negatively affect returns. Nonetheless, returns are still attractive, especially when compared to those reasonably expected by equity investors in the current market.
In fact, the return profile for mezzanine investing is so attractive (and opportunities so plentiful), that many private equity funds facing the option to either write an equity or a mezzanine financing check are opting for mezzanine debt for the foreseeable future. Why not? It is hard to pass on situations where the return is in the low 20% range, the lender is only covering the third or fourth turn of EBITDA, and there are an abundance of companies with needs above and beyond the confines of senior debt capital.
It is fortunate that the mezzanine players are stepping up to the plate. Since asset-based financing is still the norm for middle-market and lower middle-market businesses, few private equity transactions would be taking place without mezzanine money. While equity sponsors recognize that funding half the value of a transaction is the way the game is played today, few are willing to write checks representing an even larger proportion.
The Economic Winds
The economic recovery, although plodding, is certainly behind the transition from asset-based to cash-flow lending. The duration of the deep freeze in the credit markets from late 2008 through early 2010 is still having an effect on capital markets to this day. During that unprecedented time, few deals got done. Many private equity sponsors have been sidelined from completing deals for nearly two years. Deals were put on hold because senior debt was not available. Because of the scarcity of financing, the offering purchase price on companies was forced downward, often failing to meet seller expectations.
During the global recession, companies made bold and unprecedented decisions to merely survive. Headcounts were reduced to essential personnel only. Later, more jobs were eliminated and many of the workers who remained were asked to do more and take a pay cut. Spending was slashed in every area. Fixed costs were deleted when possible. Variable costs were minimized. Supply contracts were renegotiated. Research and development and capital expenditures were deferred indefinitely.
Many of these decisions were wisely made by leadership teams that had weathered previous downturns and recognized the severity of this recession. Others were forced to make more difficult decisions than they would have otherwise. Lenders, through new covenants, transitions to asset-based loans or reduced lines of credit for working capital, forced radical cost-cutting behavior. Having experienced the economic storm we have weathered and its impact on revenues and cash flow, the cost cutting does not seem as radical in hindsight.
As we are lifted from deep recession and economic/business patterns begin to normalize, we are seeing some businesses set new high water marks each month in categories such as productivity, revenue, working capital, cash flow, customer additions and new orders. Anecdotal evidence indicates that surviving businesses are battling with fewer competitors; consequently, both their market share and the pricing power for their goods and services are growing.
On top of all this, businesses are operating with extremely lean resources and minimized spending. With vivid memories of cost-cutting decisions made during the past two years, business leaders will be slow to add key jobs, spend more, and invest in research and development, equipment and other capital expenditures even when this spending is deemed to be in the long-term interest of the business. Business leaders understand the need to invest in people, strategic plans and long-term assets, but they continue to defer these investments to maximize cash flow.
After all, EBITDA is the basis for purchase price valuations by would-be buyers. Why would business owners dilute earnings in the short run through investments when they can maximize the purchase price for the business? Quality businesses are commanding premium purchase prices due to the confluence of many factors, but the following stand out the most: 1.) scarcity, 2.) efficient processes by intermediaries, 3.) unprecedented revenue and profitability by streamlined businesses and 4.) pent-up demand by private equity sponsors.
Private Equity Competition Resulting in Premium Pricing for Businesses
Given the massive overhang of raised private equity capital, there is certainly pent up demand to do deals. Quality companies that will be put on the market during the remainder of 2010 and going forward into next year will command premium prices as hungry private equity firms try to put their money to work. Private equity sponsors cannot maximize their management fees and carried interest opportunities when capital is not deployed.
Our Memories Are Short
Funding private equity transactions at premium prices can only be resolved through meaningful participation by senior lenders. Already, banks are lining up to compete and meet the investment appetites of private equity sponsors chasing quality (and even marginal) businesses. Seemingly, lenders’ willingness to complete deals is triggered more by a need to diversify bank balance sheets, presumably to dilute real estate holdings, than it is a need to grow the overall book of business. Not surprisingly given the big bailout and recent financial reform legislation, financial institutions today are managing their business to appease regulators first, stakeholders second. As a result, banks may accept lower profitability and greater credit risk when pitching new clients or renewing terms for existing relationships to improve balance sheet compliance at the expense of earnings and possibly common sense.
According to Paul Howell, senior vice president of corporate banking at Texas Capital Bank, “Lenders are forfeiting too soon the pricing discipline that was gained during 2009 and 2010.” Given the extreme volatility in the market, an uncertain political landscape, and the recent demonstration of only a modest recovery, “the fact that many banks are relaxing the recently achieved pricing improvements in an environment where credit costs remain high is mind-boggling,” Howell said.
As dealmakers, our memories are short. Or, our memories are selective in supporting our individual missions, mandates and livelihoods. As a result, cash-flow lending and lender creativity are on the rise again.
Chaitan Fahnestock, managing director at Riveron Consulting, is primarily responsible for market strategy, engagement delivery, client satisfaction, practice development and employee training, retention and recruiting. He has 17 years of public accounting, corporate governance consulting and transaction advisory experience with emphasis in relationship development, engagement team leadership and new market expansion. Today, he is responsible for promoting Riveron’s core buy-side, sell-side and post-transaction financial consulting services by leading business development strategy and implementation. Prior to joining Riveron, Fahnestock served Grant Thornton as business development executive for three years, Jefferson Wells International as business development manager for six years and Ernst & Young in its assurance and advisory practice and business development unit for five years. He earned a Bachelor’s degree in accounting from Oklahoma State University in 1992 and is a Certified Public Accountant.