debt


petcoWhen Petco Animal Supplies agreed to be acquired by CVC Capital Partners and the Canada Pension Plan Investment Board for $4.6 billion, the Dow Jones Industrial Average was trading around 17,800.  The market had recovered from the August swoon that turned out to be the worst month for the index in five years. Concerns about a slowdown in China, falling oil prices, and possible rate hikes by the Federal Reserve, sent the index into a tailspin.  Now, a mere 90 days removed from that correction, the Dow stood within three percent of its 2015 high water mark, and little concern was expressed about mega-deals, such as the Petco transaction, getting to close.  Press releases for the deal indicated a closing would happen in 1Q2016.

When the deal was announced, it was also disclosed that the transaction would be supported by $3 billion in acquisition financing, underwritten by Barclays, Citigroup, Royal Bank of Canada, Credit Suisse, Nomura, and Macquarie.  The broad lender support was a function of the company’s strong credit profile and a favorable following with investors after multiple recapitalizations, which is reflected in its trading profile in the secondary loan market.  Further, PetSmart’s acquisition debt had been trading a favorable rates in the secondary market, boosting interest. However, the deal was subject to syndication that would happen in 1Q2016.  While there has been no indication with any issues in closing the deal, there is cause for concern.  When the debt package was originally negotiated, the credits market were choppy,  now they are downright turbulent with bankruptcies accelerating and junk bond issuances declining by over 70% year-over-year.  While these bankruptcies are primarily related to the energy markets and energy dependent segments, they have put a malaise into the large cap buyout credit market as a whole.  Notably, in January, Citigroup tweaked the terms of Petco’s loan package to make it more attractive to potential syndication partners.

I proffer an example of the credit market’s uneasiness in the case of Mills Fleet Farm Group. In 2015, KKR agreed to buy the family owned retailer of rural consumer goods, including pet products, for $1.2 billion. Mills Fleet operates 35 stores in Minnesota, Wisconsin, Iowa and North Dakota.  The deal was set to close in late 2015, before it ran into trouble with its debt package. No sell-side capital markets deck was willing to take the paper, and KKR was forced to sell finance a large portion of the debt package against a backdrop of large retailer earnings misses, which drove up pricing.  The sale of Mills Fleet closed on Leap Day 2016, fitting.

While we may not be able to draw a direct correlation between Mills Fleet and Petco, the deals fall into the same buyout class.  Further, if you look outside of these transactions not many large cap LBOs are closing.  Most of the recent multi-billion deals have involved strategic acquirors.  Ultimately, we expect the Petco transaction to close, but there may be more bumps in the road along the way.

/bryan

Note: This blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change.  While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.

 

 

gordonOn December 14th, PetSmart agreed to be taken private in an $8.77 billion transaction led by BC Partners, a European based private equity fund with a history of consumer and retail investments, largely outside of the US. The deal, the largest private-equity buyout of 2104, values PetSmart at 9.1x the company’s adjusted trailing twelve month earnings before interest taxes and depreciation.  PetSmart’s equity holders will receive $83.00/share in consideration if a superior bid does not emerge and the transaction is approved.

The deal described above reflects a 39% premium to the prevailing per share equity price just prior to the disclosure of Jana Partners, an activist investor, equity position in the company in July 2014.  BC Partners and its co-investors — Caisse de depot et placement du Quebec, Longview Asset Management and StepStone Group, LP — outbid Apollo Global Management and KKR & Co., among others, for the asset. The buying group is financing an estimated 6.5x EBITDA to fund the transaction.  Citigroup, Nomura, Jefferies, Barclays and Deutsche Bank have committed to provide $6.95 billion of debt to pay for the deal. The financing package consists of $6.2 billion in fixed debt, expected to be split between roughly over $4 billion of term loans and $2 billion of bond, and a $750 million asset-based revolver to support daily operations. 

I am an on record as predicting that a transaction involving PetSmart was unlikely.  My view was that the necessary equity premium to justify a transaction PetSmart would have been exceedingly hard to generate for a private equity fund and that the strategic buyer landscape was small. I correctly surmised a combination between PetSmart and Petco would have too many impediments (though Petco was not given a real opportunity to buy the company but may proffer a superior bid if so chooses), including regulatory concerns. However, I underestimated how much debt financing would be available for a private equity buyer to support the purchase price.  In my defense the debt markets were roiled by macro fears at the time of prediction.

In thinking about the implications of the transaction, I offer the following summary:

  • Financial Engineering at Work. I view this transaction as a triumph of financial engineering.  A combination of excess liquidity in both the public and private debt markets as well pent up demand for large cash flow generating assets by private equity made this transaction viable.  The buyers must believe there are additional cost rationalization opportunities beyond the $200 million Profit Improvement Program management announced on the November earnings call.  More than one bidder who dropped out of the process proffered their view that additional opportunities appeared evident to support the required debt load. I am not expecting much change to the strategy and operating framework David Lenhardt laid out on the May 21, 2014 earnings call.  While being outside of the public reporting sphere, save for any public debt requirements, will allow PetSmart to pursue some strategies that sacrifice near term profits for long term growth, the anticipated transaction debt load will limit flexibility in this regard.  Moving PetSmart forward will be more about better execution of tactical store level decisions and incremental strategies, than “big bang” opportunities.
  • Lost Transparency. As we have detailed here previously, the pet industry lacks performance transparency. The vast majority of manufacturers and retailers are private companies or divisions of public enterprise with limited disclosure requirements. As a result, the industry is starved for timely fact based performance data. A publicly traded PetSmart provides the general public insight into the direction of the industry. That information is both free and timely. The company’s quarterly conference calls provide a wealth of information on category level performance and pet consumer trends.  Once private, this transparency will dissipate.  We think that is a real loss for the industry.
  • Not the Last Transformational Deal.  The take private of PetSmart is not the first transformational deal of this cycle and it won’t be the last. The number of large private pet companies across industry categories has swelled over the past five years. Whether it is an acquisition of Blue Buffalo, a public listing for Big Heart Brands, or a sale of Hartz Mountain, we expect that more big deals are on the horizon.

/bryan

Note: This blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change.  While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.

debt freeOne of the most frustrating aspects of following the pet industry is the lack of transparency we have into the operational results of bellwether companies that comprise the market.  With only a handful of pure-play public companies, and even fewer with meaningful analyst coverage, we are left to rely on publicly available market studies, which are often dated and/or at a cursory level, expensive third party research, or, more often than not, rumors and conjecture.  As evidence, approximately 25% of search terms that led people to this blog are related to market rumors (e.g. “Blue Buffalo acquired”) or data searches on private pet company performance (e.g. “Petco 2012 EBITDA”). However, the availability of cheap leverage to fund organic and acquired growth is providing us a rare opportunity to understand how some of these large private pet names are performing.

In October 2012, Moody’s Investor Services assigned a B3 rating (speculative) to a $250 million private bond issuance from Radio Systems Corporation, the privately held market leader in pet containment products and training systems.  The proceeds from the issuance went to replace existing balance sheet debt and purchase a putable equity stake valued at roughly $90 million.  According to Moody’s, the transaction would leave Radio Systems with a debt-to-EBITDA ratio of 4.7x.   The report also states that the company generated sales of $270 million for the twelve month period ended June 30, 2012.  So what can we glean from this disclosure?

  • Based on the company’s debt-to-EBITDA of 4.7x, this would imply Radio Systems had somewhere in the neighborhood of $50 million – $55 million in trailing EBITDA as of June 30, 2012.  Based on $270 million in sales for the coinciding period, this would imply an EBITDA margin of 18.5% – 20.0%, a good metric for a company of this size in this segment of the industry but certainly with room for expansion.
  • If we valued Radio Systems at an EBITDA multiple similar to the Sergeant’s Pet Care Products / Perrigo transaction or based on the public trading multiples of Garmin or Spectrum Brands, this would produce an implied enterprise value for Radio Systems of $500 – $550 million.
  • Finally, it appears safe to assume that TSG Consumer Partners, whose equity put is being acquired, will make a 3.0x return on its investment of $30 million made in 2006.  This returns Randy Boyd to full ownership of the company.

Moody’s rating of Blue Buffalo’s $470 million financing (rating B1) also provides us some salient insight into the company and its capital structure.  According to Moody’s, the proceeds of the transaction will go to fund a special dividend for the owners, including equity partner Invus Group.  While Moody’s did not peg a debt-to-EBITDA multiple for Blue Buffalo at the time of the transaction, it does state that “Moody’s expects that the company will be able to generate sufficient free cash flow to de-leverage rapidly, such that debt-to-EBITDA will be below five times in the next 12 months.”  The report also states that the company generated sales of $400 million for the twelve month period ended March 31, 2012.   So what can we glean from this disclosure?

  • If we assume the debt financing reflects the total leverage of Blue Buffalo, it is safe to assume that the company generated somewhere in the neighborhood of $80 – $90 million of EBITDA for the twelve month period ended March 31, 2012.  Based on $400 million in sales of the coinciding period, this would imply an EBITDA margin of 20.0% – 22.5%, a very good metric for a company of this size in this segment of the industry, especially one who is funding a national television advertising campaign.
  • Setting aside whether they were true or not, the rumors that were swirling around earlier this year that Blue Buffalo was entertaining sale dialogs with a starting price of $800 million, denotes an implied revenue multiple of 2.0x and an implied EBITDA multiple of +/- 10.0x, which do not appear out of line, maybe even light on the profitability side of the equation.
  • This confirms, what many people speculated, that Bill Bishop had sold a meaningful portion of the firm to a third party equity firm sometime within the last three years.  Invus, which has an evergreen fund structure, and therefore can hold positions for long periods, is a sensible partner.  Invus is also well credentialed in food, with historical investments in Keebler, Harry’s and Weight Watchers.

Finally, Petco Animal Supplies is again tapping the debt markets for $550 million in senior notes.  You might recall the company refinanced its balance sheet to the tune of $1.7 billion back in 2010, in part to finance a $700 million dividend to its owners, enabling them to repatriate 90% of their invested capital.  This time around, the notes along with balance sheet cash will be used to fund a $603 million distribution to shareholders.   I hashed out the Petco situation here before, but the most salient point that can be gleaned from Moody’s disclosure is that the company grew revenue from $3.0 billion to $3.3 billion from 2011 to 2012, a rate consistent with Petsmart for the same period, reflecting a greater equilibrium in the balance of power.

Net net, while much of the above might have been pieced together by an informed observer these conclusions were often difficult to corroborate because we lacked factual information.  One benefit of low interest rates, is we have gained some transparency in the process and therefore can substantiate some of the speculation rampant in the industry.

/bryan

They say there are two certainties in life, death and taxes.  That’s not entirely accurate since death comes at the end of life, but that is probably just quibbling.  Taxes are a certainty however, whether of not you choose to pay them.  If the 2012 presidential campaign has illuminated anything definitive to date, it is that not all income streams are equal from a tax standpoint; those who make the majority of their income through buying and selling investments (the Mitt Romney’s and Warren Buffet’s of the world) have much lower effective tax rates because their income is treated as capital gains instead of ordinary income — 15% versus 35% at the highest level.  Some form of equity is looming on the horizon.

In 1993, the Clinton Administration sought to tackle a $300 billion federal deficit through government spending cuts and increasing personal income taxes on top earners.  This resulted in a budget surplus in 1998, which grew to $230 billion by 2000. The surplus was a central discussion point in the 2000 presidential campaign.  George W. Bush suggested America was “owed a refund” and campaigned under a promise to lower taxes on the wealthy if elected.  The net result was the 2001 Economic Growth and Tax Relief Reconciliation Act and 2003 Growth Tax Relied Reconciliation Act, collectively referred to as the “Bush Tax Cuts”.

The Bush Tax Cuts lowered ordinary income tax rates 3%-5%, phased out the estate tax, reduced the marriage penalty, lowered rates on income from dividends and capital gains, and increased exemptions.   Critics argue over the long term impact of these changes, but two things are hard to dispute: a) the Bush Tax Cuts resulted in U.S. government losing billions of dollars of revenue over a 10 year period and b) keeping the cuts in place have become a central political platform for the Republican party.   While I am no political handicapper, the combination of a swelling U.S. deficit (and therefore the need for more revenue streams), the growing income gap between the wealthy and the middle class (as evidenced by the “Occupy” movement), and the clear improbability of the GOP winning both the White House and the Senate, mean the Bush Tax cuts are all but dead on the stroke of midnight December 31, 2012.

The implications of Cinderella leaving the ball are meaningful, as evidenced by the table below:

Estimated Changes Upon Expiration of Current Tax Program
2012 2013E % Increase
Ordinary Income 35% 43.4% 24%
Long-Term Capital Gains 15% 23.8% 59%
Qualified Dividends 15% 43.4% 189%
Estate and Gift 35% 55% 57%
Source: Moss Adams LLP Year-End Tax Planning Guide, November 2011

The question many are asking is whether these changes may light a fire under M&A for family owned businesses in 2012.   After all, if you own a business worth $100 million and  you sell in 2012 versus 2013 you save yourself at least 8.8%, but possibly much more if the”Buffet Rule” is enacted into law, which would put a minimum tax rate of 30% on all income streams if you make over $1 million annually.

History would tell us that taxes alone are not sufficient enough to push people towards transactions they would otherwise defer.  However, history has not seen this level of increase in the capital gains rate since the 1967 – 1972 period when rates increased 11.5%, but over a period of five years.  Here we are talking about 8.8% over night.  Further, the market has never enjoyed the levels of liquidity currently in the marketplace, from both strategic acquirors and private equity firms.  Excess liquidity tends to correlate with rising purchase prices.  Throw in a pinch of uncertainty regarding Europe over the next 24 months and you might have a convergence of circumstance strong enough to call some to action.

Despite the stars aligning only a subset of the market should be interested in this reality, and that would be companies on the larger end of the spectrum.  Yes, as enterprise value increases the impact of the capital gains rate changes increases, but more importantly so do transaction market multiples.  According to GF Data Resources, the spread between the multiples garnered by businesses worth greater than $50 million is a fully 2.0x in a leveraged buyout versus those with lower enterprise values.  The data shows that the “size premium”, so to speak, increased a full 1.0x in 2011.  Absent attractive purchase prices, people tend to sit on the sideline no matter how their tax bill changes from one year to the next.

Net net, I think 2012 will be a strong year for M&A because of the total market dynamics, but I don’t think taxes alone are going to stimulate a plethora of activity that would not otherwise be there on other merits.

/bryan

In order to experience some modicum of success as a writer, you need to provide compelling content that people want to read.   In our media blitzed society this generally requires one to take a provocative position on some issue.  While I certainly try to challenge my readers to think more broadly on a range of topics related the pet industry, there are only a few storylines where my rabble-rousing has enjoyed a high level of consistency;  the topic of Petco is one of them.

Again, let me state I have nothing against the company per se.  In fact, Petco, and its better looking twin sister Petsmart, provide a necessary and valuable service to both companion animal owners and the industry at large.   That said, they suffer from a fundamental structural challenge, namely their access to cheap high quality labor is limited, which undermines their ability to effectively service customers on a consistent basis.

The other area where I say the “dog has fleas” with respect to Petco is when comparing it to Petsmart.   I wrote about it here.   The basic premise was while the industry had grown nicely since Petco was taken private for a second time, the financial disclosures related to its recent debt refinancing implied that Petsmart had put Petco in its rear view mirror.  I then left it at that.

Unbeknownst to me, San Diego Reader columnist Don Bauder decided to pick up my ball and walk it over to Petco headquarters (also located in San Diego).   He put my musings to Petco Chief Financial Officer Mike Foss here, in an article questioning the benefits of buyouts.

Notably, in Bauder’s article, Foss asserted that “By virtually every single metric — sales, profit, cash — we’re better off than in 2006.”  Given the size of the debt refinancing it is easy to see how profits and cash are up, because interest costs are down and debt is up, albeit not enough to offset the decrease in the effective interest rate as, according to Foss, Petco’s refinancing is saving it $18 million in annual interest expense.   It’s not hard to believe that sales are up either given that the market has grown consistently over the past five years and the pet majors have maintained the lions share of the retail industry’s sales.  What is more notable to me, however, is that Foss said nothing about operating cash flow or same-store-sales, the two most important metrics to measure the health of a retail property.

Net net, while Foss may dispute my assertion, he certainly did little to refute it.   Further, if my analysis was really that wide of the mark, he wouldn’t even have taken the time to put his spin on the situation.

/bryan

If you have followed my pet industry musings for any duration, you know that I am not a big advocate of the service paradigm offered at large independent pet specialty chains — PETCO Animal Supplies, Inc. (“Petco”) and PetSmart, Inc. (“PetSmart”).  That is not to say I don’t see value in their services, as they play a fundamental role in growing the broader pet market.  Notably, I am and will continue to be a Petco customer.  Their store is only a mile from my residence, and while my purchases there constitute an increasingly shrinking percentage of my pet product basket, they offer me a level of convenience that I can’t find from my other pet vendors.

When we adopted our first dog, like moths to a flame we immediately went to Petco to buy our staples and stock up on food.  Over time I have moved my dogs onto other meal programs and built relationships with other product vendors.  As a result, my true need for Petco has diminished.  However, the reasons my traffic declined was one of product selection, and not what I constantly harp-on — the mediocre service paradigm that Petco, and PetSmart for that matter, offer.   It is this service paradigm that has enabled smaller independent pet specialty chains to take share.  The net result has been significant capital inflows into these secondary competitors as evidenced by Roark Capital’s acquisition of Pet Valu, Inc. and Irving Place Capital’s acquisition of Pet Supplies Plus/USA, Inc., the number three and number four players in the market respectively as measured by store count.

The service conundrum Petco and PetSmart find themselves in is unlikely to abate.  Both companies rely on legions of low priced labor that is prone to churn.  As a result, the average Petco and PetSmart front line employee never develops the expertise and relationships necessary to compete with the Pet Food Express, Inc. and Mud Bay, Inc.’s of the pet world, who differentiate themselves through the expertise they provide to their customers both in terms of product selection and in store service.  Glassdoor.com can tell you all you need to know about the challenges of working for Petco or PetSmart.

Notably, the potential upside of these higher touch service formats attracted Petco Executive Vice President and Chief Merchandising Officer to take the helm of Pet Supplies Plus.   You can read Jim Meyers message about the departure here — Message from Jim Myers-PETCO.   Petco management has not exactly been a revolving door, but there has been consistent changes over the past three years.   All this despite, as the New York Times reported, “the company did not have a negative quarter throughout the recession.”  So why is it that five years after being taken private in a $1.85 billion transaction by TPG Capital and Leonard Green & Partners is the company not considering a public listing in the best initial public offering market we have seen in years?

One reason might be that the owners are quite happy with the benefit they are receiving from the company’s cash flow.  In November 2010, the company sought a $1.1 billion credit facility to finance a dividend to its shareholders.   The loan was later upsized to $1.225 billion.  Upon consummation, the transaction would have leveraged the company 5.5x latest twelve months EBITDA according to sources close to the deal.  And therein lies the rub.

If in fact Petco would have been leveraged at 5.5x at the time of the deal it would imply that the company was generating $200 million in EBITDA ($1.1B / 5.5 = $200M).  According to public filings, when the company went private its LTM EBITDA at the time was reported to be $209 million (as of July 30, 2006, the last reporting period prior to the transaction).    In contrast, PetSmart reported LTM EBITDA as of January 31, 2011 (the period most closely correlating with the time of the Petco leveraged dividend)  of $665 million in EBITDA.   It’s LTM EBITDA as of July 30, 2006 was $460 million.   Net net, PetSmart’s EBITDA grew ~ 45% over this timeframe where Petco’s was flat (a generous interpretation).

From a valuation standpoint, PetSmart’s equity has been on a tear the past twelve months, rising ~ 43% according to Yahoo! Finance.  This values the company at 7.8x LTM EBITDA on an enterprise basis.  Subtracting the net debt yields an equity market capitalization for PETM of ~ $5.1 billion.  Applying this same enterprise value multiple to Petco’s $200 million in EBITDA yields a value of $1.56 billion, ~ 16% less than the take private price.  Subtracting the $1.225 billion in debt yields an equity value of, well, not much.   While this comparison fails to account for all the interim distributions, including the leveraged dividend that has lowered the private equity firm’s cost basis, there is no way to put a smile on it.

Further, the above analysis appears conservative when you consider that Standard & Poor’s reported that Petco was actually leveraged 7.6x LTM EBITDA as of January 29, 2011, up from 6.0x at the same time one year prior.  Further, Petco sought an amendment to its loan agreement in February 2011, just three months post issuance.

Net net, it is clear that all is not going according to plan at Petco.  Management defections and flat EBITDA growth over the past five years, is symptomatic that consumers do not find its value proposition all that compelling.   Has it lost its mojo?  From my perspective — yes.  However, don’t count them out by any means…yet.

/bryan

Mezzanine debt, sometimes referred to as junior debt or subordinated debt, came into vogue during the “go-go” 1990s buyout boom.   The origins of mezzanine debt are rather cloudy, but the instrument was invented to allow private equity firms the ability to limit the amount of equity dollars they put at risk in a deal.   Once a purchase price was agreed and senior debt (bank financing secured against the assets of the company) was arranged, buyers would offer mezzanine debt funds the opportunity to get 15% – 20% return by taking an unsecured position ahead of the equity slug.   Interest rates on mezzanine debt was in the low teens with 66% – 75% of the interest being cash pay and the balance paid-in-kind interest (interest that accrues and is added to the principal and then paid when the debt is retired).  The balance of the targeted returns were achieved by issuing at-the-money or penny warrants to the debt provider.

Limited partners (pensions, endowments, and the like that make up the capital used by institutional funds) liked the mezzanine concept as it enabled them to get attractive risk adjusted returns, with the cash interest protecting them on the downside and the warrants juicing their returns on the back end.  In a strong bull market of rising tides, mezzanine funds did very well as default rates ran very low and equity returns exceeded expectations.  Many hedge funds got into the act by making similar investments in operating companies with a more risky profile.  These investments targeting slightly higher returns than institutional mezzanine.

Shortly after the Internet bubble burst, mezzanine debt, in its traditional form, went in to decline.  A flood of cheap bank debt made mezzanine less attractive to sponsors and the emergence of publicly traded Business Development Companies, offering one stop financings (senior debt, junior debt, and equity — often referred to as unitranche debt) , cut into mezzanines traditional markets.   Any gaps between purchase price multiples and bank availability was bridged through the emergence of second lien notes (debt that took a second position on fixed assets and real estate), which offered a lower cost of capital relative to mezzanine debt.   Traditional lenders, including second lien, were offering to cover as much as 95% of the purchase price, so there was no need to offer excess returns to anyone.  Between 2005 – 2007, mezzanine debt went in to hibernation.

By 2007, mezzanine began to make its comeback.   As purchase price multiples reached into the stratosphere mezzanine returned to filling its initial mission.  Any incremental dollar of debt meant an incremental $0.50 – $0.75 of purchase price.  Based on this improving demand function, mezzanine debt funds raised $15.7 billion in 2007.  In 2008, nearly 60 funds raised over $34 billion.  These funds were meant to fund the last mile on leveraged buyout transactions but then the music stopped.  By 1Q2009 the buyout market was bone dry.

Flush with capital, mezzanine debt providers were left to contemplate a “buyoutless” world.   In response to these changing circumstances funds separated into two camps — those determined to define their own identity (Camp I) and those intent to wait out the storm (Camp II).

While Camp II sat dormant, Camp I’s initial response was to seek to make stand alone mezzanine investments.  After all, mezzanine looked like a good tool to achieve short term liquidity relative to taking equity at depressed prices, if it was even available.   However, these funds were not well situated to do de novo deals, having historically relied on the diligence of their equity partners to get comfortable with a transaction.  As a result, targeted returns spiked and mezzanine debt became visually and economically unpalatable.   Lenders began targeting returns of 25% – 30% to compensate for their diligence risks (after all there was no equity to save them).   Many awesome deal stories followed.

However, as the buyout market has roared back to life, Camp I has shown that its evolution has staying power, while Camp II has returned to business as usual.   In fact Camp I is pitching itself as an alternative to institutional equity — faster, cheaper, without the governance hangover.  Notably, terms sheets from Camp I funds look much like those from the old public traded business development corporations, only without the senior debt.   Today a typical mezzanine term sheet will have a subordinated debt component, with cash and paid-in-kind interest and dollars allocated to an equity investment in lieu of warrants.   These mezzanine funds can stretch far on valuation because they have the downside protection of the coupon and no private equity partner to be beholden to.  The script has flipped.

As we enter into a period of uncertainty with respect to how this cycle will build and how long it will last, mezzanine debt players are better situated than their counterparts to take deal volume from other parts of the capital structure.   As a result, I expect to see standalone mezzanine debt volume grow dramatically through the balance of the year.

/bryan

“Dozens of people spontaneously combust each year.  It’s just not really widely reported.”

— David St. Hubbins, Spinal Tap

During the period spanning 2H2008 to 1H2009, I enjoyed a steady stream of inbound calls from companies seeking debt.  About half of those calls were from people thinking that I had something to do with a bank that made loans; the balance were from businesses, large and small, seeking additional capital to fund their operations.   Most of them were beyond help, due to the state of their business and/or collateral.  However, a small handful were beyond help, not because they were bad credits, but because the national banking system achieved a level of gridlock not seen in my lifetime, or probably anyone’s for that matter.

The market panic caused a significant contraction in available debt.  Market prices for even high quality credits trading on the secondary market plummeted (30% – 40%); default rates spiked (a 400% increase to ~ 13% in December 2008); spreads widened materially (+400 BPS on Commercial Paper, one of the lowest risk financial investments); capital ratios increased (Tier 1 capital requirements for lenders increased from 4% in May 2009 “Stress Test” to 7% at Basel III); and bank numbers contracted (active cash flow lenders went from 154 in 2007 to 18; FDIC has closed approximately 300 banks as a result of the recession).   No wonder people could not get a loan.

The above should be no surprise to anyone who follows the financial news.  However, today, some 12 months removed from those panic induced calls, people look at me quizzically when I tell them that debt is in fact available.   The looks I receive are a cross between “what you talking about Willis?” and the glare my grandfather bestowed on me when he thought I was pulling his leg.   Yes, debt is available, but like spontaneous combustion it’s not really widely reported.

To be clear, a significant portion of the business ecosystem is still unable to access debt.  Asset based loans remain widely available, with lower advance rates, but there are a lack of lending institutions that write check sizes under $5 million.  For those banks that remain in this market, many of them continue to be saddled by under performing real estate portfolios and credit standards that are harder to crack then getting into the wine cellar in the presidential war bunker.   As such, loans for small business remain very hard to come by, and this will continue for some time.  However, debt for large middle market businesses is not only widely available, but the trend has turned silly as banks seek to invest (no loans no loan revenue) as much of their available capital with the highest quality credits.  Eventually, competition will drive these banks to begin moving down the size and quality stack until the lower echelons are again able to access cost effective debt capital.

One prime example of debt market health is the availability of leveraged dividends.  A leveraged dividend involves taking out debt to pay, as you might expect, a dividend.   In short, a significant percentage of capital is not remaining in the business, it’s going in to the pockets of shareholders (often times private equity funds) with the liability remaining at the corporation.   When leveraged dividends are widely available, it is the first sign of debt market excess.   Now consider that over $40 billion of leveraged dividend recaps have been declared in 2010, according to S&P.   These levels exceed 2005 totals and are competitive with 2006/2007 volumes, the base of the last market peak.  The shareholders of HCA, Dunkin’ Brands, Burlington Coat Factories, Ascend Learning, Getty Images, Pelican Products, and Petco have been the chief beneficiaries.   While many of these companies operate in attractive industries that are “recession resistant” (health care, education, pet retail), many of them are not owners of highly predictable recurring revenue streams that would put a lenders credit committee at total ease.

Likely a better measure is what I am seeing in the market as it relates to debt issuance.   Based my purview, the credit market remains bifurcated.  However, as a company’s trailing twelve months (“TTM”) Earnings Before Interest Taxes and Depreciation (“EBITDA”) approaches $10 million, it becomes much more widely available.  Further, in the last 6 months, we have seen a trickle down effect.  In 1Q10 the benchmark was $15 million in TTM EBITDA, while today it is in the +/- $8 million range and goes lower, albeit not much, for companies that are in non-cyclical industries and have predictable recurring revenue streams and performed well throughout the recession.  A caveat is that if EBITDA has spiked materially over the last twelve months, a three or four year average is applied to establish “baseline” EBITDA.   It also helps if the company is backed by a third party equity provider.

What is also notable is that bank hold sizes have gone down considerably.    What this means is I am seeing syndicate deals on transactions that we would traditionally see a lender signal source.    Companies seeking $100 million loans are ending up with 5 – 7 banks in their credit versus 1 – 2 pre-meltdown.  This means it is actually easier for $10+ million TTM EBITDA businesses at the lower end to get credit than at the higher end, as you don’t need to get the entire credit industry on board with your transaction.    I realize this is backwards, but welcome to the current credit market reality.

Finally, availability does not necessarily correlate to volume.    Currently, lenders are seeking a minimum of 40% of enterprise value be in the equity account.   Therefore a company that is valued at 6.0x TTM EBITDA can only get up to 3.5x leverage, and more likely 3.0x.   Thus, no meaningful EBITDA means no meaningful debt.

Net net, we are not in a flush lending environment by any means, due in part to government imposed capital requirements, but debt is available if you fit in the current sandbox.

/bryan

 

 

 

 

Rewind 18 months and the outlook for the private equity world looked rather bleak.    Debt financing was drier than the Sahara in July,  the economy was pulling down the financial performance of portfolio companies causing defaults at alarming rates, and limited partners were actively looking at ways to pull commitments to avoid over allocation to the alternative asset class.   You didn’t need to be Goose to see that “this is not good Maverick”.   Further, you did not have to roam far within the financial services community to find someone who thought the party was over.

As a general rule, the investment banking community has never been overly sympathetic to the private equity cause.  There is not a private equity pro who does not believe that every banker is pining for their job.   However, in the run up to the financial meltdown, equity investing had become a hustle game resulting from too much liquidity in the system.  Private equity pros lived on the road in search of “proprietary deal flow”.   They would willingly drop in on any banker that would take a meeting.  It was tough not to have a least a little sympathy as purchase price multiples reached unprecedented levels making it hard to believe fund IRRs were going to make these guys more wealthy than their predecessors.   Further, private equity, was driving deal volume, and therefore banker bonuses, accounting for nearly a third of all domestic M&A transactions in 2007.

Today, and with the benefit of a little hindsight, it is clear that the demise of private equity was grossly exaggerated.  In fact the financial buyer community has rebounded quite nicely.  While financial buyers do not enjoy the  full economic advantage that they did 24 months ago — really cheap  limited or non-recourse debt — they are well situated for success and the market appears to be coming back to them.  Consider the following:

  • Survival of Mega Buyouts.  When the economy began to unravel many thought that the mega-LBOs of the prior 24 months would unravel, leaving private equity with a tremendous black eye.   Considering that mega buyouts, while only 5% of deal volume, accounted for 61% of private equity investment in 2008 and 2009, it was safe to assume that as they go, so goes the industry.  That said, save for the demise of Chrysler, the mega-buyouts have withstood the brunt of the storm.  Yes it is true that banks have had to work with many of these credits out of self interest, but this does not account for the  mere trickle of private equity backed bankruptcies that we are currently seeing.   Likely more applicable is that private equity purchased significant amounts of debt on the open market, at a discount, to preserve equity value in their portfolio companies.  As the economy stabilized they benefited from the rising prices for this debt, thereby juicing returns.  While there have only been two $1+ billion deals announced in 2010, the fact that any can get done shows that there are “green shoots” on the private equity transaction landscape.
  • Credit Returns.  While credit may not be as abundant as it once was, certain classes of companies are enjoying access to leverage at attractive rates within favorable structures (e.g., covenant lite, PIK toggle, etc.).    Companies that generate more than $10 million of annual EBITDA are the prime beneficiaries of banks loosing their clutches on credit.   Facing competition for these credits from the high yield market, banks are increasingly willing to loan to companies perceived to be “safer”.   Garnering 3.5x – 4.0x leverage appears to be straight forward, while we have even seen a 6.5x stapled financing (senior plus subordinated debt)  on a consumer non-cyclical company.   Debt drives private equity’s ability to pay, as every dollar they can borrow is a dollar they can kick in as equity, assuming a 50%/50%  debt/equity split.    Given that the majority of LBO deals involve companies that breach (in a good way) this EBITDA hurdle, one would expect to see private equity deal volume spike as a result.
  • Deal Stats Trending Favorably.  For the third straight quarter, private equity deal activity posted a gain both in terms of number of transactions and dollars deployed.   Private equity completed 300 investments totaling $14 billion.  This is up from 238 deals for $13 billion in 4Q2009.  Notably, 1Q2010 saw the first deal greater than $2 billion completed since the prior year period — CPP/TPG/Leonard Green acquisition of IMS Health ($5.2 billion).

Private equity is also enjoying the benefit of overreaching strategic buyers.   Strategics, possessing flush balance sheets, and lacking competition in the M&A markets have failed to embrace sellers in a way that casts them in a favorable light.  Instead they have assumed a very conservative approach, as evidenced by the increasing use of earnouts, the expanding size of deal escrows, and the elongation of transaction timelines.    Net net, private equity in its core market is alive and well.

/bryan

I’ll readily admit that I don’t know much about inflation.  It’s hard for my generation to appreciate the concept since the majority of our wage earning years have been characterized by a general absence of an inflationary cycle.   Since I graduated from business school in 2000, inflation (as measured by the Consumer Price Index for all urban consumers (CPI-U)  has not breached 5%.   In fact, over the course of 2009, we experienced considerable deflation, with negative growth in the CPI-U for eight months of the year.

So why is it that I am holding inflation indexed bonds in my portfolio?  That is a good question.   The reason I went into TIPS six months ago, was my belief that inflation was inevitable.   The unprecedented amount of liquidity that has been injected by the U.S. government in an effort to stabilize and re-energize the economy requires it.   Or does it?

As a general rule, when excessive liquidity is injected into the market place with an rapidity it leads to an inflationary cycle.  The logic equation is that the recipients of that cash will find themselves with an excess inventory of funds and bid up the prices of goods and services.  The sellers of those goods and services find themselves cash rich and pass along the favor.  The declining value of the currency causes people to part with these excess funds as opposed to holding on to them.   As evidenced by the graphs below — M1 (the money supply) and a trade weight currency exchange index (DTWEXM) — these very conditions are in play right now.  The money supply expanded by more than $1.7 trillion in 2009, more money than is necessary for transaction purposes.

So why is it that we find ourselves with sustained low inflation despite excess liquidity?  Notably, the process of inflation is not precipitous, especially in a complex economy and during a period of economic decline.  It is not hard to fathom an entity, be it a person, business, fund, etc., holding excess liquidity (read: hoard cash) out of fear despite the erosion of value resulting from falling currency rates, because the alternatives are less attractive.   The media often refers to this as the “money on the sidelines”.   Despite a strong economic recovery as measured by the stock market, people remain fearful of future problems stemming from the bloated balance sheet of our economy, and, as a result, they continue to be more than happy to hold onto their monies, even if they are less precious tomorrow than today.    One only needs to look at consumer spending figures and read about wage stagnation to see evidence of this pattern of behavior.

Additionally, economic meddling exacerbates the realization of inflation by delaying capital outlays.  Bailouts of individuals and institutions mean they can postpone deleveraging events and calls on collateral.   Notably stimulus packages spread out spending over a longer time horizon which prolongs the effect.   Further, much of the current stimulus sits on bank balance sheets in the form of excess reserves — money that provides savers assurance that their collateral is safe.  Because this money is sitting idle, since banks are not lending, the drop in the velocity of money has offset the dramatic increase in the supply of funds.

Despite these realities, the conundrum will not last.  We are talking monetary physics here after all.   If one is to believe the great economist Milton Friedman, the peak effect of on economic growth of excess liquidity will be felt between 18 – 30 months after the rapid expansion of the money supply.  Further, the impact on consumer prices will then be felt a further 12 – 18 months downstream, meaning, in monetarist terms, the inevitable spike in inflation would occur sometime in late 2011.

Whether you subscribe to Freidman’s paradigm or not, it is easy to conclude that that when banks start to lend, the velocity of money will increase and inflation will follow as a result.  Since the recovery is expected to be slow and bumpy, it is not hard to envision that the velocity of money will remain low throughout 2010, keeping inflation in check until late 2011 at the earliest.   Further, high unemployment and excess production capacity will keep wage growth in check (not hard to imagine) further muting inflationary pressure.   Finally, if you believe Bernanke the government could, at its discretion, unwind the special lending programs, pull back the reserves and sell of the securities it has purchased, thereby avoiding the problem of monetary expansion all together.

However, in my opinion inflation will likely be realized sooner than Freidman would  have predicted.    Notably, the Fed cannot put the brakes on the program as contemplated without risking pushing us back into a recession.  This is highly political, so nothing will be done until it is clear that we are out of the woods.   As a result, the money will remain in the system allowing for velocity to increase sooner than anticipated.  Further, I expect there to be political pressure both from within and abroad for us to inflate our way out of our current deficit.   This would be achieved by the Fed allowing inflation to increase while holding interest rates low.  The net impact would be negative cost of borrowing on an inflation adjusted basis.  This would stimulate both borrowing and spending.  Further, wages would increase, which in turn would increase the tax base, thereby enabling the government to pay off its massive deficits.   This is too seductive a solution for politicos to keep their hands off, especially if the President’s approval ratings continue to dwindle.   However, this program is hard to enact in a periods of high unemployment, so the recipe is not ideal.

That all being said, it seems clear we are not headed for double digit inflation anytime soon.   Our current deflationary cycle is still in effect and the combination of other factors — falling commodity prices currency valuations, fear, low velocity of money, high unemployment, etc. — will insulate us from significant systemic shocks.  However, expect modest inflation to return in the medium term and be seen in markets were capacity is constrained first.

/bryan

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