Credit Solutions for the
1970s All Over Again?
Observable Credit Markets
Senate discussion on an arms treaty with Russia/ Soviet Union…Inflation rising at a blistering annual pace…Tourism slowed by fears about gasoline prices. Though these headlines are easily mistakable for a March 2022 edition of the Wall Street Journal, they are in fact three featured articles from the front page of the New York Times on July 27, 1979.
It was always unlikely that M&A volume would keep pace with a record-shattering Q4 2021, and markets had been taking a breather before new geopolitical and economic considerations set in. During Q1, credit market participants shifted focus to Russia’s invasion of Ukraine, rising oil prices and increasing inflation. The novel concerns temporarily sidelined deals and subdued appetite in the syndicated market, but private credit remained open and abundant.
Refinancing and dividend recapitalization activity replaced some of the slower acquisition volume, before M&A volumes rebounded late in the quarter. Across the middle market, increasing concern about borrowers grappling with labor shortages and higher input costs in the face of anticipated interest rate hikes has caused lenders to reassess certain sectors.
Total leverage dipped below 4.5x for the first time in several years, perhaps a sign of either more cautious lenders or weaker credit quality of new loans.
Note that observations were limited for deals <$250MM in size.
Loans clearing 5x leverage are increasingly rare in the lower middle market and a vast majority of deals closed between 4 – 5x.
Pricing ticked up by ~30 bps despite lower average leverage; likely attributable to refinancing volume relative to LBO activity.
Dividend volume only slightly lagged LBO volume during the quarter, as M&A activity temporarily cooled early in the new year.
Default rates remain near record lows, but market participants are keeping a close watch on inflationary pressures and impact to borrowers.
How to Differentiate in an Ultra-Competitive M&A Environment
Configure Private Credit Metrics
The following information is based on Configure’s proprietary dataset, compiled based on lending conditions in the middle-market. EBITDA for borrowers ranged from less than $10 million to greater than $50 million, with an emphasis on transactions executed by operationally-focused sponsors.
Leverage reached post-pandemic highs due in large part to sizable LBOs closed in late Q1.
Pricing has remained at a consistent level in spite of other credit flexibility. Depending on fund dynamics, many lenders demonstrate willingness to lose on structure but not price.
Dividend recapitalizations held an outsized share of the deal pipeline until M&A roared back late in the quarter.
Similar to direct lenders taking share in traditional BSL territory, upper-middle market structuring is seeping into documents for companies with <$30MM of EBITDA.
How to Differentiate in an Ultra-Competitive M&A Environment
Global M&A (on both volume and value perspectives) hit record highs in 2021 and, after a lull in early Q1, resumed an accelerated pace in 2022. Although unlikely to match 2021 levels, indications suggest another flurry of deal flow thanks to longer-term economic optimism, a steady transaction pipeline, and an abundance of capital. Buyers (and their third parties) have been pushed to the brink in search of the right assets. This has provided sellers and their investment bankers with ample opportunity to deploy seller-favorable processes, timelines, and structures. In recent months, Configure has witnessed multiple sell-side processes that incorporate some combination of the following: limited (14 days or less) to no exclusivity period, exclusivity contingent upon no financing “out”, and running multiple buyers in parallel right up to a closing. At the same time, sponsors are struggling with the same human resource and staffing constraints experienced by their portfolio companies and the broader economy.
Managing internal resources and avoiding dead deal fees has always been important to sponsors. Wasting time and money on a deal that doesn’t close is even more critical in this resource-constrained market. Unfortunately, both have become increasingly challenging in the current deal environment. From our observations, there are several tactics that are utilized to narrow the funnel, lock up deals earlier, execute more efficiently, and minimize the heartache (and headache) of losing the deal.
1. Approach Sell-Side Staples with Caution
Commonplace with most sell-side transactions is a crisp, one-page summary of financing support. Respectable logos and a healthy leverage range bolster bid levels and encourage sponsors to stretch on valuation. While it is tempting to hit the easy button and rely on the sell-side leverage read, Configure has repeatedly seen the strategy backfire in critical situations. In several recent processes, the sell-side advisor provided staple financing has fallen through, forcing buyers to scramble for new sources of debt capital under severe time constraints. In many instances, lenders that provide financing reads do so with imperfect and partial information or with little conviction. Buyers should not assume those are firm indications and will benefit from an independent understanding and underwriting, even if it requires additional investment of time on the front end.
2. Early and Broad
Every sponsor has a number of key “relationship lenders” and those lenders are afforded varying degrees of partnership. Regardless of these relationships, general best practice, particularly as the credit markets become more choppy, is to engage with lenders early in the process and to approach more than “the usual suspects” with solid diligence information. Lenders are also feeling the effects of heightened M&A activity, which can result in unexpected outcomes for sponsors. Lenders are subject to the same resource constraints as sponsors and will often not be able to dedicate the necessary resources to appropriately diligence and underwrite a deal before exclusivity is granted to the sponsor. This can lead to a re-trade, sub-optimal leverage and other terms, or backing out entirely. Additionally, institutional perspectives are changing rapidly in today’s environment, and a lender’s appetite for a deal or sector may shift if they have losed another deal in the sector (leading to industry concentration) or, conversely, a deal within the same sector or with the same sponsor has soured. By approaching a wider array of potential lenders, a sponsor can identify the group(s) with equal parts capacity, experience, and enthusiasm for the deal.
3. Committed vs Commitment
If a lender emerges as a favorite early in the process, some sponsors are choosing to accelerate that lender and advance towards committed financing at the LOI stage, even if not required by the sell-side. While this increases the risk of dead deal fees (particularly legal fees), speed and certainty is becoming increasingly important in sell-side processes. While lenders can be “committed” to pursuing a deal, a full “commitment” comes typically in the form of a “Sungard commitment” which parallels the outs reflected in the sponsor’s LOI or purchase agreement. A fully-funded bid package with no financing outs can be a strong differentiator in terms of both surety and timing to close. In instances where diligence does not allow for a fully committed deal prior to exclusivity (on the part of the sponsor and/or on the part of the lender), advancing lenders as deep into diligence as possible can provide the sell-side with similar levels of confidence around the buyer’s ability to close.
In this environment, carefully selecting which opportunities to chase is critical for sponsors in order to minimize the distraction and hard costs of deals that do not ultimately close. Whenever possible, sponsors should quickly determine which opportunities are high-interest and pursue those with vigor and full commitment of resources while culling the moderately (or less) interesting opportunities from the pipeline early. Once the determination has been made to pursue an opportunity, incorporating these strategies for acquisition financings can assist with a smooth transaction and elevate probability of close.