Reed Smith attorneys recently attended a conference held in New York where the state of the U.S. middle market for leveraged finance was discussed. Ronald Kahn, Managing Director and Head of the Private Placement Practice at Lincoln International LLC, a Chicago-based investment banking firm, delivered the keynote address. Ron is a leading expert on mezzanine capital, having authored numerous articles on the subject, and is a frequent speaker on raising debt and equity capital. The following are the highlights of his address. Note that these comments relate generally to companies with earnings before interest, taxes, depreciation and amortization (“EBITDA”) of less than $50 million.
Senior Debt Market
- Senior debt is much more difficult to obtain, with fewer active senior lenders today than a year ago, and smaller hold sizes, especially for cash flow loans
- In the case of larger mid-market loans that need syndication, the agent lender will require the right to "market flex" (i.e., change) the pricing, terms and loan structure in order to complete the syndication; alternatively, senior loans are more likely to be “clubbed” so that the borrower knows the terms of the financing and the participants before completion of the financing
- Senior debt that can be structured as an asset-based loan rather than a cash flow loan may have a better chance of getting funded and with more favorable pricing and terms, as many financial institutions are only providing asset based loans at the current time
- Senior lenders are beginning to require increased amortization of term loans—amortization has gone from 1 percent in year one, to between 5–10 percent with increasing amounts in subsequent years
- As a result, asset-based loans, currently priced around Libor plus 225–275, may be an attractive alternative to cash flow senior debt, which is often priced today at Libor plus 525– 575.
- Borrowers should expect tighter leverage ratios (e.g., 2.75x–3.25x senior; 3.75x–4.25x total) and more stringent debt service coverage ratios
- Senior lenders are requiring a higher percentage of equity to be contributed as part of the leveraged buyout (“LBO”) (e.g., no less than 30 percent, and often 40–50 percent of total capitalization)
Mezzanine Debt Market
- There is a resurgence of mezzanine debt following the decline of the second lien and highyield markets; many of the buyers of second lien paper have disappeared from the market (e.g., CLOs, CDOs, hedge funds, BDCs)
- Availability of mezzanine capital has not decreased despite the credit crunch. In fact, mezzanine funds are the only capital providers that have the same, if not more, capital to deploy today as they did before the credit crunch
- Mezzanine loan pricing and terms have not increased as much as increases in senior debt pricing:
- Target return: 15–18 percent
- Interest rate: 12 percent cash, 2–4 percent payment-in-kind
- No-call provisions: up to 2–3 years (with prepayment penalties after no-call period)
- Warrants and equity co-invest have re-emerged and are almost always required
- Mezzanine pricing is often constrained so the spread between mezzanine and equity returns is between 500–750 bps
- The quality of mid-market LBOs may be improving as a result of the increased equity requirements, tighter senior financial covenants, and reduced amount of available senior debt
- Mezzanine lenders are often seeking second liens as downside protection against trade creditors
- Despite the credit turmoil, purchase price multiples of middle market LBOs have come down only slightly, with many good companies still selling at multiples of 7–8.0x EBITDA
- Increasingly, seller notes and earn-outs are being used to bridge the funding gap
These are general observations about the state of the middle market leveraged finance and do not necessarily represent the views of any particular financial institution, private equity firm or other funding source.