In March, members of the Wharton Private Equity Club coordinated a roundtable discussion between four influential lenders to talk about the currently robust debt markets, trends in the sub-debt markets, the impact of hedge funds, and ways firms can differentiate themselves from the competition, among other topics.
Jerome Egan (WG’01) is a senior vice president at TCW/Crescent Mezzanine, a Los Angeles-based mezzanine provider with approximately $4.7 billion of capital under management. TCW typically invests in senior subordinated notes with equity upside (obtained through warrants or equity co-investments) in connection with sponsored LBO transactions. Its typical investment size is approximately $80 million, but it can commit up to $400 million for any given transaction. TCW invests across industries.
Jeff Foley (WG’ 99) is a director in Wachovia Securities’ Leveraged Finance Group, a leading provider of leveraged finance solutions, including senior debt, second lien, mezzanine, and high yield products serving both financial sponsors and traditional large and middle market corporate clients.
J. Gardner Horan is a senior vice president in GE Commercial Finance’s Global Media & Communications Group. With over $7 billion in assets under management, GE’s Global Media & Communications Group offers a wide range of financing solutions to middle market and large cap media, communications and entertainment companies ranging from $20 million to over $1 billion. These include senior secured debt, mezzanine and high yield, second lien, and equity co-investments.
Jeff Kilrea serves as the co-president of CapitalSource, Inc. CapitalSource (NYSE: CSE) offers a wide range of financing solutions, including senior term loans (first and second lien), asset-based revolvers, mezzanine financing, and equity co-investments. CapitalSource targets middle-market companies that generate EBITDA between $5 million and $35 million on an annual basis. It can arrange transactions up to $200 million.
WPEC: In your opinion, what are the primary factors that have led to today’s robust debt markets?
JK: The robust debt markets are being driven, in my opinion, by one primary factor: market liquidity. There is a glut of capital in the market today from CLOs (Collateralized Loan Obligations), BDCs (Business Development Corporations), Hedge Funds, new Commercial Finance companies and Regional Banks, not to mention significant capital from PEGs (Private Equity Groups) anxious to deploy capital as they seek their next round of fund raising. From a debt perspective, some of these new or alternative sources of capital did not even exist 5 to 10 years ago. From an equity perspective, the opportunity for higher returns generated by PEGs has increased the dollars committed to this sector from endowments, pension funds and other investors, which also has contributed to the debt markets.
JE: I think today’s debt markets have been largely driven by the interest rate environment as well as the enormous amounts of capital that have been raised by buyout firms. Just as equity sponsors have pushed the envelope on purchase price multiples, so have lenders done with leverage and the pricing on that leverage. In our space and with the investment sizes we deal with, the high yield market is our primary competitor. Spreads are tighter now than ever, making mezzanine a less competitive option. However, many sponsors still prefer large “private high yield” issues because mezzanine providers can be more flexible on call protection and other features, making it a more flexible security from the sponsor’s point of view.
GH: Low default rates have been a key factor. I don’t have the exact numbers on hand, but I believe they are approaching 45-year lows. This has kept losses off of the books, which has made it easier for institutional investors to raise money. This, in turn, has increased liquidity and pushed yields down. Companies are less likely to default with lower rates. It’s a cycle.
JF: The primary factor driving the robust market conditions, particularly in the leveraged loan market, is the market liquidity from the continued fund raising by CLOs and other institutional investors. Despite record M&A activity, the demand for new paper continues to outstrip supply, resulting in favorable pricing and structures from an issuer perspective. As previously mentioned, low default rates are another important factor driving the current environment.
WPEC: The question on everybody’s mind — how long are the good times going to last? What external factors do you believe will lead to an eventual softening?
GH: We think the debt markets will start to tighten towards the end of this year or the beginning of 2008. Eventually housing and manufacturing weakness will take its toll on the economy and filter down to the credit markets. However, several factors such as covenant-lite deals could delay this tightening. As always, industry specific issues will also come into play. For instance, in the media space, advertising dollars from the 2008 presidential election may offset weakness in the broader advertising markets.
JK: It is difficult to predict how long the good times will last, but some type of underlying market correction will be necessary to curb the current enthusiasm. The correction could come in the form of an increase in the interest rate environment, which will impact debt service capabilities and debt leverage of borrowers interested in making acquisitions. The correction could also result from material credit agreement defaults by borrowers in the credit markets, which should lead certain lenders, either temporarily or permanently, to exit the business. Many of the new competitors have not experienced the inevitable cycling of the credit markets so it will be interesting to witness their behavior in a challenging credit market.
JE: If or when the defaults start to occur, then we’ll see discipline re-enter the market. There are also many questions regarding what rights holders of second lien paper will have in a default. I also believe that if or when default rates increase, buyout firms will realize that their capital structures are made up largely of hedge funds with a “loan-to-own” mentality.
JF: While we have seen some volatility in the high yield market over the past few weeks following the pull back in equities, we believe that the favorable outlook for the economy coupled with strong market technicals should result in a continuation of the robust financing market in the near term. I would agree with others that the key driver to a pull back in the debt market over the long term will be a material increase in default rates. Additionally, a continued correction in the equity market would likely result in a debt market correction.
WPEC: A lot has been written about how the private equity industry has become more competitive over the last few years, but the debt markets have also become more competitive. How have new entrants (BDCs, hedge funds, etc.) changed the market?
JE: The vast amounts of capital raised by hedge funds and second lien funds have fundamentally changed the financing landscape. As long as there is such a significant amount of available capital, there’ll be intense competition. Financing sources need to figure out a way to distinguish themselves. Relationships with the sponsors become extremely important.
JK: The competition from new entrants has certainly fueled an aggressive pricing and leverage environment. Over the past year we have experienced tighter credit spreads, increasing leverage multiples, and reduced fees for lenders. Typically, I would say this movement is contradictory, but competitive forces, market liquidity and the desire for asset growth continues to drive this phenomenon.
GH: In addition to hedge funds entering the market, we’ve seen the larger banks (JP Morgan, CSFB) move down into the middle market. This has increased competition and changed the structure of some of the middle market deals — they are starting to resemble large cap deals in terms of covenant restrictions, acquisition baskets, etc.
JF: With the new entrants to the market, deals continue to be structured more aggressively in terms of higher leverage, less restrictive covenants and lower pricing. Additionally, we have seen more mezzanine investors working directly with sponsors to arrange a syndicate of mezzanine financing and eliminate the need for an arranger. Delivering real-time updates on the financing markets combined with proprietary acquisition and financing ideas are important points of differentiation among firms.
WPEC: As mentioned, it seems that covenants have gotten much less restrictive, particularly at the high end of the market. Have you had to become more competitive on covenants?
JK: Covenants are just another dynamic in this aggressive marketplace. “Covenant-lite” deals (limited to incurrence tests) are popular for larger market transactions. In the middle market, lenders have gotten much more aggressive on covenants. Transactions are typically limited to two or three financial covenants (fixed charge, leverage and interest coverage). A lot depends on the deal, whether earlier stage or mature, how the covenant package will be structured.
JE: Covenant-lite deals have become quite common. We have a couple of key covenants we insist on, but otherwise we usually go with the market and trust the sponsor to act appropriately, even if they’re not contractually required to do so.
GH: We think that covenant-lite deals are a temporary market offering. I’m not sure they are going to be around in nine months. They are definitely hot right now, though. Issuers who generate greater than $50 million in EBITDA who are looking to come to market over the next few months will most likely get pitched covenant-lite deals. That EBITDA threshold is decreasing on a regular basis.
JF: After only $5.9 billion of covenant-lite transactions in 2005 and $27.5 billion in 2006, 2007 has seen an explosion in the volume of covenant-lite transactions, with over $32.0 billion issued year to date. Over the past month, almost every meeting I have had with a client has included a discussion of covenant-lite structures. Not only has the current market resulted in these structures with one or no-maintenance financial covenants, we have also seen significant loosening in many other covenants, such as acquisition baskets, debt incurrence baskets and restricted payment capacity.
WPEC: What current trends are you seeing in the sub-debt markets? Is the pendulum swinging back towards mezzanine from second lien as a result of the higher interest rates in the past few years?
JE: The mezzanine market has definitely experienced a resurgence in the past year, largely due to second lien financing becoming less competitive as interest rates have risen. I also think some sponsors are realizing the positive economic times can’t last forever and so are becoming more sensitive to who is in their capital structure — a highly syndicated second lien group or one mezzanine provider with whom they have a good relationship. This is particularly true in the case of highly leveraged deals where the first one or even two years are forecasted to be extremely tight on a free cash flow basis.
JK: For a period of time earlier this year, credit spreads for second lien and mezzanine financing were sizable: possibly 200/300 bps. With an increase in LIBOR and tightening of the second lien market, we have seen an increase in mezzanine debt in transaction structures. This has also been driven by an increasing leverage marketplace where we have seen more aggressive structuring, 4x/6x/6.5x with HoldCo PIK Notes, necessary to help PEGs finance LBOs.
GH: We’ve also seen mezzanine providers get more active over the past year by lowering their pricing to the low to mid-teens. They’ve also shown a willingness to take larger tranches as a way to differentiate themselves. Much of this is generated by the type of investor taking the mezzanine debt. Hedge funds that are typically in second lien tranches are open to unsecured sub-debt to obtain enhanced yields (generally by 2% or 3%). These deals are structured similarly to second lien financings, excluding the security. More traditional mezzanine investors will generally have higher yield requirements and more restrictive terms (i.e., non-call periods, etc.)
JF: The mezzanine market has been very attractive for issuers over the past year as alternative to both second lien and high yield tranches. As compared to second lien, issuers frequently view mezzanine as more patient capital and as mezzanine coupons have trended lower and LIBOR has trended up, pricing is more competitive. Also, as mentioned by others, with the increase in tranche sizes for mezzanine, we have seen mezzanine with “bond-like” covenants and favorable call structures replace some volume in the high yield market.
WPEC: To follow up on Jerome’s comment — have private equity firms become more adamant about who ultimately holds their debt? Furthermore, has this changed the amount of paper you are looking to hold?
JK: Balance sheet management is always something of interest from a lender’s perspective. Even in this frothy market our hold sizes continue to be in the $20 million to $30 million range, depending on deal size and PEG preference. PEGs are more interested in who is holding their paper, and it certainly has bearing on who is awarded debt mandates. PEGs want to see their relationship lenders hold more meaningful positions and bank groups don’t want to see one or two lenders of a syndicate (for a middle market transaction) control voting. Most PEGs, unless necessary, don’t want to see hedge funds leading their deals because of the portfolio management uncertainty or loan to own reputation.
GH: I think the general trend has been for relationship banks to hold less, but we try to hold more to further develop the relationship with the sponsor. Who ultimately holds the debt has become more of an issue in the middle market. Issuers can get good terms from a wide range of institutions so many of them don’t want to take the risk of having hedge funds in their syndication group.
JF: The answer varies by private equity group, but if I were to try and generalize, for broadly syndicated transactions we have seen less focus on the final hold positions for the lead arrangers and more focus on allocations to second lien and mezzanine markets. Also, for mezzanine financing, most private equity firms have strong preferences on who is approached for mezzanine opportunities.
WPEC: An industry perception exists that the “mega funds” receive premium terms on their deals because of their brand name and relationships. Does such a premium exist in the middle market? How much does a firm’s brand name and your relationship with that firm matter when securing debt for a new transaction or working out a difficult situation with an existing company?
JK: In middle market transactions, I am not sure that either proprietary deal flow or sponsor preferences exist. A PEGs “brand” name may add some cache to the process, but with so much PEG money chasing middle market deals, and recognizing that most PEGs are well banked, I-Bankers and intermediaries can afford to widen the net when representing companies in the sale process. From a debt perspective, I think relationships are important when PEGs are looking to secure financing for their acquisitions. This relationship may be worth 25 bps or a last look at a transaction, which certainly is representative of the increased competition for deals. Relationships are built at the front end, but solidified and maintained based on certainty of execution and delivery. Credibility is key, and that includes behavior from a portfolio perspective. Not all deals go as we all hope and there will inevitably be difficult discussions at some point. Rational thinking is part of relationship building, and PEGs value lenders that act as true partners.
JE: I don’t think the middle market gets anywhere near the terms that the mega funds get. We definitely go into a deal with a middle market sponsor with different expectations than when we invest with a mega fund.
GH: Relationships and reputations are important in the middle market — a well known operator in the space certainly helps syndication. Lenders will stretch further for groups who have a demonstrated track record in a certain industry.
WPEC: Have any of you participated in the growing buyout markets outside the United States? What are the primary differences that lenders must consider in these transactions?
JE: We invest globally, mainly in Europe and Australia. The primary differences with the U.S. relate to creditors’ rights if things go badly for the company. The bankruptcy rules are significantly different in other parts of the world, most of which follow “strict priority,” which greatly lessens the ability of subordinated lenders to have their voices heard in a restructuring.
JK: Last year we opened an office in London and are looking to capitalize on the growing European LBO marketplace. The European marketplace is different from the States and we have encountered numerous legal challenges. Given the flow of dollars from U.S. PEGs into Europe, we view this as a tremendous opportunity, but recognize this effort is still early stage. We have been primarily a participant in other people’s deals to date, but believe we have our first agency role locked up.
WPEC: Do you have any general advice for sponsors when they are dealing with a company that has not performed well and may need to restructure? What can a sponsor do to improve its chances of a successful outcome?
GH: The best advice I can give is to understand the investor base and communicate. Issuers and sponsors who fail to communicate can leave a bad taste in investors’ mouths, which will ultimately affect their willingness to bend on certain issues. Be responsive to information requests. Sponsors who keep the lender group informed fair better than those who do not.
JK: I agree. The best advice I have for PEGs that have troubled situations is maintain an open and honest dialogue with your lender. No one wants to be surprised. Don’t limit communication to good news. Communication of bad news and a clear plan to seeking a solution is the best course of action. This does not insure a positive outcome, but working together with your lender and keeping all parties apprised is the favored approach.
JE: A sponsor needs to do the right thing. Whether that’s putting in new money or working in partnership with the company’s creditors, or even handing over the keys to the company — it’s those sponsors that maintain their reputation for acting properly that keep financing sources interested in doing their deals.
JF: I agree with all the points made. Open and honest communication is critical.
WPEC: Have your views on dividend recaps changed in the current environment?
JK: We have done our fair share of dividend recaps and will continue to evaluate them, but pushing the leverage envelope in order to pay dividends is not necessarily something that interests us. Dividend recaps can be a means of retaining solid performing assets in the portfolio. I do like to see PEGs with some level of monetary commitment post recap. While there is still risk, it offers a little added comfort knowing the PEG still has principal exposure.
JE: We will not finance a dividend recap. We believe strongly that the equity sponsor needs to have risk capital in the deal. We’ve passed on many dividend recaps that have done very well the past few years, but our belief hasn’t changed that it’s a fundamentally bad investment.
GH: Dividend recaps have grown dramatically over the past three to six months. With so many sponsors currently raising new funds, the need for monetization or partial monetization has increased. Generally, the debt markets will go a bit deeper in the capital structure on an acquisition vs. a recap of the same business. This is due to the validation of value that is provided with an acquisition. In a recap, market value of a business is more subjective. That being said, this is still a great time for sponsors to pursue a recap.
JF: Another sign of the robust financing markets has been the volume of dividend recaps over the past year. The leveraged loan market (first and second lien) has been very receptive to dividend transactions with very little, if any, discount to the comparable LBO leverage multiples, especially for known issuers with proven track records. We have also seen a significant surge in volumes in the high yield and mezzanine markets for holding company dividend transactions. Many of these have been issued with favorable call structures and used to pre-fund a dividend ahead of an IPO or other exit opportunity.
WPEC: Finally, do you have any advice for private equity groups trying to differentiate themselves in an increasingly competitive industry?
JK: Knowing your particular sectors of expertise cold is an important step when it comes to differentiation. This will help with the sourcing of deal flow and raising of capital. Whether the PEG is sector specific or has certain Partner specialists in a more generalist setting, it is my opinion that these groups are the most productive and spend time on deals they have a higher percentage of winning. It also makes the debt raise somewhat easier as well.
JE: I agree. Sponsors need to stick to their areas of expertise. Some are very good at retail, some at financial services, etc. Today, many buyout shops who find themselves with so much capital invest in industries they have no experience in.
GH: Tough question. I agree that in-depth knowledge of a sector goes a long way towards differentiating a group. This knowledge can stem from either past deals in the space or from an operating partner or advisor who used to work in the industry. These factors help create a sense of camaraderie and show a commitment to getting the deal done. When acquiring a division of a larger company, it is important to be considerate of the public relations issues that are present for the sellers in such a transaction.
JF: Develop key areas of knowledge and expertise and then develop relationships with management teams and bankers in the sector. Work with these bankers and management teams to deliver proprietary, value-added acquisition ideas for new platform companies and add-ons to existing portfolio companies.