Drinker Biddle & Reath LLP hosted a roundtable discussion Nov. 6, 2008, at its Philadelphia office, regarding “The State of the Debt Markets in Private Equity Transactions in Troubled Times.” At the roundtable, 34 representatives of private equity sponsors, senior lenders, mezzanine lenders and investment banks participated in the discussion with Drinker Biddle’s private equity and finance attorneys. Flip Huffard of The Blackstone Group gave introductory remarks.
The discussion among the participants highlighted the issues and challenges facing the private equity market during the current credit squeeze and economic slowdown:
- Most of the participants in the private equity world said they are positioning to be able to withstand the current market. Attendees agreed that it is a very difficult time to finance new deals. As one attendee said, there has been an “unprecedented shut down” in the market and “massive system-wide deleveraging.”
- Money center banks, finance companies and collateralized loan obligations (CLOs) are primarily on the sidelines, with the main exception being defensive loans. CLOs are struggling with problems with organizational documents restricting the types of securities they can hold, which has created an opportunity for hedge funds to enter into the restructuring finance arena, especially funds with capital locked in over the next two to three years. The problem is that there are more entities seeking money than the hedge funds can accommodate, so yields must be high (i.e., mid- to upper-teens – compared to yields of LIBOR plus 350 a year ago) to grab a fund’s attention. These changes are redefining typical consensual priming debtor-in-possession (DIP) financing structures: now a third party (not a group of the existing secured lenders) is acting as a backstop for financing with secured lenders participating in the financing if they so choose. As a result, first lien lenders are losing power to the new money being brought into deals. These opportunities are not without risk. Some industries are suffering systemic structural issues that need to be considered. Attendees suggested that investors looking to enter into this arena are wise to involve a “partner” with expertise in restructuring since this is a departure from the M&A transactions private equity companies typically handle.
- Compared to last year, large cap market volume is down 32 percent and middle market volume is down 9 percent. Deal size and the deal numbers are down as well, with lenders finding it difficult to arrange a syndicate for commitments in excess of $75 million. Spreads continue to widen and rates in the LIBOR plus 500 range and LIBOR floors of 3 percent are not uncommon. The equity component in deals has increased to 30 to 60 percent of purchase price. Up-front fees have increased as well. Financial covenants are significantly tighter. Cash-flow lending is virtually non-existent and declining asset values are impacting liquidity on the asset-based lending (ABL) side by reducing borrowing base capacity. As one attendee put it, it is the age of the “good money” deal: weaker companies are finding it more and more difficult to obtain and afford financing, while stronger ones are closing deals. Attendees discussed the use of equity cure rights as a way to ride out the storm, but the consensus was that while they may be useful in strong credits, they are of limited value in many cases and may not truly address the fundamental underlying problems. Certain industries are suffering systemic problems, such as housing, construction and automotive, and will continue to have difficulty in their quest for capital. Other industries are expected to offer opportunities, including healthcare, technology and aerospace.
- An observation was that the lending market is mercurial, with capital flowing in and out in an erratic and unpredictable manner. Consequently, a company seeking capital is wise to grab it when it can, regardless of price, because it may not be available for long. There is a belief that the $700 billion bailout will not be enough to significantly improve liquidity in the short term, as banks have been using what they have received so far to de-lever and shore up balance sheets instead of lending. > Andrew Greenberg, CFO of GF Data Resources LLC and Managing Director of Fairmont Partners provided the following data points on deals completed in the $10 to 250 million range (90 percent of which were in the $10 to 100 million range): see table
- A recurring issue is the fundamental disconnect in pricing between buyers and sellers. The difference between bid and ask is still too far apart for many deals to get done, which, along with liquidity issues, has affected the ability of companies to buy debt back. Although equity sponsors are considering the repurchase of debt, the challenge is finding the cash to do it and then determining if that cash might not be employed elsewhere to greater advantage. The attendees split on the importance of maintaining good lending relationships. Some believed a good working relationship with a bank was essential in getting deals done while others believed that banks are going to act more and more selfishly, and relationships will mean less and less as long as current conditions continue.
- A bright spot has been mezzanine lending which, according to one participant, “hasn’t been busier.” Companies are desperate for money and mezz lenders have been able to negotiate better pricing, lower leverage, high warrant coverage (which in better times could be difficult to get), and sometimes a second lien. One mezz lender remarked that, “3.5x is the new 4x” regarding leverage. Additionally, senior lenders, looking to de-lever their positions, have welcomed mezz lenders, treating them more like core capital and providing more rights to them in intercreditor agreements than has been seen in the past.
- For companies in serious trouble, the old rules do not apply. Typically, existing lenders would provide DIP financing and provide liquidity for a company to continue operations. Now, those lenders are reluctant to provide DIP and exit financing. Consequently, many companies that entered bankruptcy thinking they could find money to reorganize and emerge from bankruptcy cannot, and some companies are forced to move from reorganization to liquidation as a result. Ironically, the scarcity of capital is making restructuring more difficult, which could result in more companies filing for bankruptcy protection. One opportunity for healthy equity sponsors looking to grow their portfolios is the acquisition of companies with restructured balance sheets emerging from bankruptcy.
Attendees also ventured the following predictions and opportunities for the private equity market in the upcoming months:
- Third-party DIP financing.
- Continued slow-down in the middle market into 4Q and 2009; lower earnings into 2009 and lower valuations.
- Continued increase in use of mezz debt.
- Companies will continue to hoard cash (it remains to be seen whether this is to simply ride out the storm or to employ it in advantageous buying situations).
- The credit crunch and economic slowdown will weed out weaker companies and leave remaining companies leaner.
- Despite the bid/ask disconnect, there are some extraordinary purchase opportunities in the market for companies that can find the money (although many companies may be more focused on surviving the the next year than looking for exit opportunities).
- Although deal volume and valuations are expected to be down in the coming months, some believe financing terms (i.e., leverage and spread) will improve.
- An unknown at present is the impact on the commercial real estate market as things continue to slow down. A significant deterioration of this market could drag out the credit/economic downturn even longer than anticipated.
- There is the common belief that GE (a bellwether for financing) will not lend through the remainder of 2008; how and when it gets back in the market during 2009 will be important.
Attendees were in general agreement that many transactions will continue to face financing challenges, but there is money for deals that “make sense.” Economic developments will have an impact on future private equity deals, and we will continue to monitor the market closely.