Credit Solutions for the
Middle Market
A Fast and Furious Fourth
Observable Credit Markets
Pace of credit issuance surged from 0 to 60 in a matter of weeks, driven in large part by frenzied M&A activity. A combination of factors contributed to record levels of M&A activity in 2020’s final three months, including relaunching of delayed sell-side processes, sponsors eager to deploy dry powder, and founder/ owners seeking to equitize in anticipation of potential tax code changes. All told, Q4 2020 produced the highest quarterly M&A value since Q4 2015. Healthy activity capped off a rollercoaster year for dealmaking and demonstrates a renewed sense of confidence in markets. The only impediment in Q4 seemed to be human capital constraints. For participants in the middle market, the bolstered markets meant a return to pre-COVID terms. Appetite with credit funds drove leverage levels and loan-to-value up, while pushing pricing and amortization down. Further, lenders’ ability to quickly close time-sensitive deals hardly translated to negotiating authority in documentation. Single-covenant and cov-lite deals with generous cushions are commonplace again. Sponsors took advantage of the accommodative backdrop and receptivity in the credit markets shows no signs of slowing.
Private credit funds face a choice: chase rare, highly sought-after, COVID-resistant credits for lower pricing on less favorable terms, or pursue more risk for better pricing and documentation.
Volume has significantly lagged 2019 levels and, despite activity in the observable credit markets remaining muted, Configure’s evidence suggests new issuance is accelerating as pent-up demand for new credit is apparent, particularly in recent weeks.
Unsurprisingly, lenders are wading back into the market with caution, compressing average leverage multiples to levels not seen since 2015.
Two Sides of the COVID Coin
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. The following term sheet represents the average indication received for financing processes during FY2020.
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Two Sides of the COVID Coin
Sponsors contemplating investments in a post-COVID environment will undoubtedly face underwriting considerations related to the pandemic’s impact on financials. Not only will lenders diligence addbacks and long-term effects on a business, they also will query the short-term, possibly temporary, benefit to results. Properly positioning a borrower’s 2020 performance will be key to differentiating a credit from countless opportunities in the white-hot M&A market as well as securing favorable terms.
The boundaries of adjustments and addbacks have expanded widely in the past several years, allowing for aggressive methods of calculating EBITDA. Generous covenant cushions and elevated leverage vs book EBITDA have become commonplace. It only took a global pandemic to usher in greater scrutiny. A few suggestions to approach in negotiations are summarized below:
Securing Adjustments and Addbacks
The most common scenario in the wake of COVID-19 has been, and will continue to be, borrowers positively adjusting earnings to account for disruption and dislocation. Adjustments more likely to be viewed favorably (and therefore added back) by lenders include modifications that are temporary in nature, one-time expenditures, and/ or government mandated changes.
For example, manufacturers may have introduced overtime or additional shifts to adhere to social distancing guidelines. Healthcare providers may have invested heavily in PPE, more rigorous cleaning, or a new HVAC system. Financial services firms may have incurred substantial costs to transition employees to a work-from-home environment.
But what about revenue addbacks?
Many businesses may find that their largest loss is related to revenue. While previously rare, sales addbacks have crept into recent credit documents. Quantifying sales declines due to shutdowns vs longer-term shifts in consumer behavior is a challenging task absent sufficient post-pandemic results. However, adding back a drop in revenue due to delayed contractual arrangements, vendor shortages/supply chain interruption, or mandated customer limitation has greater footing.
To secure any addbacks, sponsors and borrowers should track all COVID-19 losses and expenses so they can be easily identified and supported. Within documentation, prepare for pushback on categories to be included and caps on certain adjustments. Although percentage-based addback buckets are achievable, it is important to consider the two-way impact of this construct and that capturing maximum adjustments are more critical when EBITDA declines vs improves.
Mitigating a “COVID bump”
On the flip side, many businesses have enjoyed a spike in demand as stay-at-home orders and increasing health and safety precautions prevailed. Buyers and lenders alike must therefore delineate a one-time sugar high vs sustainable performance improvement.
For instance, direct beneficiaries of a shift to eCommerce may tell different stories. Build-out of distribution and warehousing infrastructure could be a one-time boon for contractors, while the same development portends longer-term demand for freight carriers. Similarly, a supplier of nutritional supplements could have experienced heightened demand for immune-boosting vitamins, whereas single-use hygiene products might endure.
Differentiating the increases is necessary for lenders to ensure they are not leveraging off peak EBITDA. When evaluating sales, consider the following: volume increases attributable to historical/ existing customers or new relationships; recent trends representing a pull-forward of demand; changes to consumer behavior or broader societal shift; and geographic concentration and interstate net migration among others.
In either circumstance, best practice for sponsors and borrowers is to maintain optionality and flexibility with their financing partner(s) by agreeing to provisions and definitions at the term sheet stage while competitive tension still exists. Though unprecedented in scale and scope, the challenges COVID presents to financing transactions are not entirely unique and can be mitigated accordingly.