playbookIn October, Del Monte Foods announced that they had sold their fruit and vegetable business for $1.68 billion.  While the world will still have Del Monte canned pineapple, whole kernel corn, and Contadina tomatoes to enjoy in perpetuity, the transaction speaks volumes about the attractiveness of the pet food business relative to its human corollary.  Del Monte’s pet products business will now operate under the Big Heart Pet Brands banner.

You may recall that back in 2010, when Del Monte Foods was taken private by a private equity syndicate headed by Kohlberg Kravis & Roberts (, I postulated that the deal was not about shelf stable fruits and vegetables but a bet on the macro fundamentals of the pet industry.  The sale of Del Monte’s Consumer Products business validates my thesis, as does the recent acquisition of Natural Balance Pet Food.  The real question is what comes next?

As a general rule, private equity backed companies are not keen to keep cash on their balance sheets.  Excess cash is used to make acquisitions, delever, or ends up as dividends to shareholders.  Given the size of the slimmed down Del Monte post sale (some $1.8 billion in revenue), I don’t see the later two options as being viable alternatives. As such, I expect that Del Monte will be an active player in the pet consolidation market, and with that much cheese at its disposal the target list includes brands others cannot contemplate.  So who will Del Monte buy? We handicap the candidates:

  • Blue Buffalo. The Blue is the biggest and best name on the block. Not a month goes by without a rumor surrounding the prospects of a Blue Buffalo acquisition by a major CPG company, but the reality is that the company has limited options for suitors at the purported price tag — $3.0+ billion.  Could Del Monte take it down?  Yes.  Will they? Unlikely.  First, Del Monte’s pet line-up is very much about a product portfolio and spending all your allowance on one product company runs a bit counter to that premise. Second, private equity backed companies do not have a propensity for being top payors.  When Del Monte acquired Natural Balance for $341 million, they paid between 1.0x – 1.5x Revenue.  I’m not sure what multiple of EBITDA a $3.0 billion deal for Blue implies, but it would be far greater than the 9.0x the private equity syndicated paid for Del Monte.  While Del Monte established the market multiples that pet companies aspire to achieve through their acquisitions of Meow Mix and Milk Bone, I don’t see them doing a highly dilutive deal with Blue Buffalo; the cost benefit tradeoff is misaligned. Odds: Not good.
  • Natura Pet Foods. The fate of Proctor & Gamble’s pet food portfolio has been a source of constant speculation.  P&G was rumored to be considering offloading its pet business when they acquired Natura Pet Foods in 2010 (, which some took as an about face. They never integrated Natura, which would make it the most likely candidate among the P&G portfolio to be acquired.  Natura would provide Del Monte another power house brand in premium natural, but of greater significance is the fact it would be buying a portfolio of products (EVO, Innova, California Natural, Healthwise), not a single brand.  This would also enable Del Monte to keep Natural Balance in pet specialty, as the Natura portfolio would meet the same needs in mass.  This strategy runs into two problems, one from each side of the transaction.  First, Natura was the subject of one of the widest recalls ever in June of this year, when the company voluntarily recalled every product it made with an expiration date before June 10, 2014. It was their fourth Natura recall in as many months.  Would Del Monte buy a dented egg?  For the right price I suspect they would.  Second, a sale of Natura would only generate proceeds of less than $500 million, a rounding error for P&G, and therefore not much motivation to transact.  Odds: Possible not probable.
  • Iams Pet Foods/Eukanuba. In contrast to a Natura transaction, the sale of Iams and Eukanuba would likely fetch between $3.0 – $3.5 billion ($2.5 – $3.0 billion of that being Iams). This would be worthy of some attention for both sides. Merging Iams/Eukanuba with Del Monte’s pet food brands would make it the number two player in the market, with 20% share versus 35% for Nestle Purina Pet Care. Notwithstanding my comment about check size above, this deal would be tempting for Del Monte to consider. Iams and Eukaneuba generated approximately $2 billion in revenue in 2012 (allocating the other $300 million of segment revenues to Natura), and therefore would be attractively priced, consistent with the Natural Balance transaction. Notably, in July 2013, Del Monte tabbed Giannella Alvarez as Executive Vice President and General Manager of the Pet Business.  As part of her work history, Ginnaella spent time at P&G, albeit involved in a Latin American paper joint venture, but she may have some relevant connectivity to current leadership. However, a deal of that size would likely require the private equity owners of Del Monte to invest more equity, something private equity firms can be loathe to do.  The transaction timeline would also be elongated by anti-trust concerns.  While this deal makes a lot of sense, there are clear barriers to a transaction.  Odds: Possible.
  • Champion Pet Foods. The brand that few talk about in this conversation is Champion Pet Foods, which manufacturers and markets the Orijen and Acana brands of super premium pet food.  Champion was acquired by Bedford Capital Management in 2012, and the business has grown rapidly since the transition, benefiting from Natura’s channel exit and growing distribution offset by production complications related to a plant fire in December 2012. Champion’s regional formulations may not create production economies of scale (yet), but they garner a premium price among consumers who value a limited ingredient solution with a known sourcing pedigree.  While Del Monte wants scale in the brands it acquires, Champion is growing quickly and will become a target of major pet CPG companies over the next 12 – 24 months.  An acquisition would provide Del Monte a very compelling product stack in pet specialty.  Odds: Long, but logical.

Net net, post sale transaction Del Monte finds itself in an enviable position — with both cash and intent.  I do not expect that the company will rush into any transaction, but they have to buy and given the limited competition for premium assets in the space, look for them to strike while the iron is hot, or at least warm.


“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.






There is a growing belief – and it’s slowly being supported by market data – that the economy is improving. Traditionally, we would take this to mean that key indicators are accelerating; and, in some cases, such as manufacturing activity and worker productivity, they are. But the term “recovery” has also come to mean something akin to “not as bad as last time”; or, talking more like an economist, it’s become code for “a deceleration of the decline.”

So, whether we’re using lay language or professional parlance, we need to confront the fact that service sector activity, on which our economy is now largely based, continues to contract, and unemployment figures remain near historic highs. Both of these signposts should serve as a clear reminder that all is not well. And, despite professing that the current recession is “likely over,” Federal Reserve Chairman Ben Bernanke continues to urge caution with respect to the domestic economy.

If we move beyond the macro-indicators, there are also signs that a bottom in the transaction environment is imminent.

The most obvious key indicator is the public equity markets, where we have seen a very healthy recovery. The current bull market rally has driven the Dow Jones Industrial Average up 46%, the third-largest six-month rally in history. As a byproduct of the run-up, corporations have been able to pry open a new issuance window not seen in years. Further, credit spreads have tightened and issuance volumes of both investment grade and high yield debt will surpass 2008 figures. These have enabled corporations to access capital and much needed exits for financial investors, both of which are important to transaction velocity because liquidity drives the lifecycle.  In addition, CEO confidence, as measured by The Conference Board, surged in the second quarter into an “optimistic” reading. This means more views to the positive than to the negative. A favorable market outlook correlates strongly with corporate and financial buyer appetites.   Finally, there has been a spate of large deal announcements, driven primarily by large cap public companies seeking to capitalize on strategic synergies. These deals have changed the tone of the M&A market.

Based on available data, peak-to-trough contraction in M&A transaction volume has typically taken two years. The recessionary period of the late 1980s and the period at the outset of this century both conform to this pattern. As such, given that the current contraction began in late 2007, we would expect to see a bottom late this year. That said, we’ve seen improvements in market conditions, but we don’t believe circumstances are right for a quick return to normalcy for a number of reasons:

Sponsors on the Sidelines. While we have seen an increase in sponsor inquires regarding ongoing mandates, we have seen only a handful of term sheets and even fewer closed deals from this community. On the whole, the private equity industry is still struggling with problems within its existing portfolio. A lack of cheap debt capital to underwrite new deals has resulted in depressed sponsor-backed activity volumes. Year-to-date, global private equity activity is off over 66%, though.   The trailing four quarters have been slower than any four quarter period since the twelve months ended June 2002. Until sponsors are able to access cost-effective debt, total transaction volume will be muted.

Mezzanine Debt Not Solving the Last Mile Problem. Mezzanine debt was touted as the means through which leveraged buyouts were going to be effected when lenders scaled back on transaction leverage. It’s true that mezzanine fund-raising has reached unprecedented levels and subordinated debt has grown as a percentage of the deal capital structure, but company performance has declined significantly, rendering mezzanine of limited use for the buyout community. Further, lender return expectations have exceeded a level buyout professionals deem reasonable.  While mezzanine debt will be part of the solution during the recovery, company operating performance must improve in order for it to be accessed as intended.

Deal Velocity Absent in the Middle Market.  The composition of 2009 deal activity is heavily skewed toward transactions that are greater than $5 billion in value; but deal volume has dropped by approximately 23% in this segment. Even more telling, volume for deals involving companies valued at less than $1 billion (a traditional definition of the middle market) has fallen by over 50%. We’re seeing that most high-quality middle-market companies in the Pacific Northwest seem content to sit out the current market cycle. And deals that have gotten done, like RW Beck / SAIC, occurred at premium-market multiples that were justified by high levels of strategic value. The middle market makes up the largest percentage of transaction volume (33% in 2008); but until valuations improve, a true recovery in the transaction environment cannot be realized.

Strategic Buyers Continue to Show Caution.  While premiums paid for transactions in 2009 are well above the long-term historical average, this figure is skewed by a handful of large public deals. As an example, Dell offered a a 68% premium to the prior-day close to acquire technology services company Perot Systems. In reality, we are finding that strategic buyers are quite cautious with respect to tuck-in acquisitions. Most buyers views this as an opportune market to buy companies at cost-effective prices. But we don’t see these buyers stretching on valuation until operating results improve and financial buyers are able to provide a realistic alternative for sellers.

Ultimately, deal volume will return when the buyer’s ability to pay  and the seller’s expectations again converge. We now recognize that the market eroded so precipitously that a very large chasm was created; it’s also clear today that it will take time to build a solid and lasting bridge over that abyss. An improvement in the macro economy is definitely good for deal activity, but economic growth has to be reflected in the income statements of traditional middle market companies before we experience a return to normalized conditions.

eyeHappy new year to you all.  I hope you all had a safe and happy holiday season.  As the new year dawns, the general tendency is to fade in to prediction mode about what the upcoming year might hold on whatever front.  I’m not a great long range forecaster, and I have the equity portfolio that proves such.  Where I excel is in reading the next 3 – 5 moves in the game.   Summarizing the view from the trenches if you will.   I’m good at the middle game but far from being a grand master, able to see 10 – 12 moves forward.  However, what I am fairly confident in, is if I could warp the time space continuum, I would fast forward to 2010 and forget about 2009.   Unfortunately, I can’t do that, nor can I hold my tongue long enough to avoid making a few predictions, so here we go:

Hangover Not Cured

The economy is in the tank, and it is accelerating, not improving.  We just don’t know it yet because the Federal Reserve does not give us the numbers in a timely manner, but we should be able to infer it from the anemic retail and job reports, forecast slashing and weak earnings we are seeing.   ADP was nice enough to tell us that 693,000 jobs were lost in December, and the Federal Reserve was kind enough to make a series of ambiguous statements that they economy is in fact on life support, but without numbers people tend to shield their candle from the wind and tell themselves it will be alright.

It’s time to recognize that it is not alright and act accordingly.  Third quarter 2008 GDP contracted at an annual rate of 0.5% and politicians flocked to capital hill screaming bailout.  What will they say when they find out 4Q08 GDP shrank by over 5%+?  If this comes to be realized, and I think it will, I suspect this will be very damaging to consumer psychology.  If the consumer goes south, then we could push unprecedented levels on the contraction front.  People who are predicting a 2H09 recovery and talking about how the tea leaves are looking favorable for a cyclic rally to kickoff in April or May of this year appear to be living in an alternate reality.   Consumers psychology will not turn that quickly and their balance sheets will need to be rebuilt.  While I do not like to think or say it, I do not anticipate we will begin to see the light at the end of this recession tunnel until 2010, and that might be slightly optimistic.

The Dark Ages

As anticipated, transaction volume plummeted in 2008.   M&A volume was down a third for the year and 44% for 4Q08.  Domestic LBO volume was down 84% for the year, falling off a cliff in 4Q to $4.8 billion.   Global LBO volume was off 71%.  Almost all of the fourth quarter deal volume occurred in October, meaning that post-Lehman Brothers, all you could hear were crickets.   Wall Street should have taken the quarter off, to get a head start on taking 2009 off.

Part of the reason deal volume fell so precipitously was the lack of availability of debt capital.  Goldman Sachs and Morgan Stanley converted to commercial banks, not at their request, and banks then went in to “hoard capital” mode and have not come out of the turtle position.   Deal related debt fell to 4.9x EBITDA from the prior year period of 6.2x for deals with greater than $50 million of EBITDA and to 4.5x  from 5.6x for deals below this EBITDA threshold.

If there was a silver lining, price compression was not seen at the levels that were anticipated.  In fact deals with greater than $50 million in EBITDA cleared at a whopping 9.5x, the second highest observation ever recorded by S&P.  What this means is the quality bar was high and only the best deals got done.  With company toplines falling 20% – 40%, I expect prices to compress throughout 2009.

For the coming year transaction volume will be drive two factors burning strategic rationale or need.  Need will be driven not by buyers, but by sellers.  Properties will come to market as a result of having lost their debt facility, driven by shareholders that need liquidity and general financial distress.  Not a rosy picture.  I believe 1H2009 deal volume will be the worst ever with 1Q09 struggling to best 4Q08.   Smart companies with liquidity cushions will hunker down and ride this wave out, as opposed to going to market.  The best positioned will seek to snap up the best distressed properties for cents on the dollar and benefit as such at exit.  Further evidence of the “rich get richer” theory.

Ice is Not Fluid

Maybe the rate limiting factor to both economic improvement and improved transaction velocity will be achieving some viscosity in the debt capital markets.   Based on what we have seen TARP has done little if anything to meaningfully free of new capital to buy company side risk.   Fortune-500 companies continue to have unprecedented levels of cash on their balance sheets to insulate them from liquidity crises.  The cannot free up this capital until they can borrow.   Their bonds continue to yield mid-double digit returns in many cases.   The proposed Obama backed stimulus plan has done little to create a sense of stability in the market.  Lenders who told us to call them back in 1Q09 are now saying, call us in 2Q09, prompting us to coin the phrase “second quarter is the new first quarter”.

As some point someone is going to have to start lending at more cost effective levels than the long end of the yield curve is currently commanding or GDP will fall to unprecedented depths.   I do see this happening in 2009, the lending environment improving that is, either as a result of the government intervening by buying long term corporates, thereby driving yields down, or restricting the usage of funds proportioned in the bailout to certain activities including new originations.

Yes, 2009 will be bad.  Unprecedented levels of pain will be experienced by our nation and workforce.  There will be huge dislocation in the white collar industries, other than health care.  I hope for the best for all of us.  Live within your means, keep your senses about you, don’t follow faddish trading strategies when you do not understand the underlying market dynamics and find opportunities to celebrate the small victories in 2009.  For some, fortunes will be lost and for others made.  That who re-write the rules are more likely to fall into that later category.


From my prior post, we know that the transaction environment in the middle market is poor at best, but more likely toxic, much like the balance sheets of the banks that are constraining it.  I harbor no illusions that the financial bailout program controversially voted into law will lead to expedient removal of the most substantial roadblocks and return us to leverage buyout nirvana.  No, ae are in for chilly times.  The question is how long will the ice age last, and what will it look like?  I offer some thoughts/predictions here on debt availability, LBO transaction volume and valuation trends.

Thawing of the Polar Ice Cap

If a return of cost effective money is the rate limiting factor to a more robust transaction environment, it should be the place we start in our effort to identify potential signs of a turnaround.   There is both good news and bad news here.  The bad news is there will be no easy defrosting.  The reality is that cash flow lending is well down the debt hierarchy and we need to melt everything in front of that first.  That starts with the multi-trillion dollar commercial paper market.  It will simply take time for the heat to reach the more subordinated product suite, despite the fact that the mezzanine market is already smoldering.

Additionally, while the bailout might bolster the balance sheets of a broad swath of lenders, the ripple effect of a deep economic contraction is going to lead to a number of them going out of business (many of them due to their exposure to Fannie Mae and Freddie Mac stock).  A contraction of capital availability and the sources to provide it, is going to cause those with fresh capital to lend to be inundated with deal flow.  I’ve heard from a number of mezzanine funds that they are receiving inquires at unprecedented volumes.  If someone can provide senior capital then I would expect they would be drinking from the firehouse as well.

The good news is that pockets of debt capital do in fact exist outside of asset based loans and mezzanine. debt  Recaps such as the Furminator and Charlesbanks buyout of Tecomet, are proof positive that deals can get done if the capital structure is right and the prospects for the business are sufficient to support the underwriting risk.  Sure fees and costs associate with such deals have increased and will remain high for the short term, the well will not go dry.  That said, don’t look for the polar ice cap to thaw until unemployment peaks and the signs of recovery are readily evident.  Look for signs of life in 2Q2009.  Albeit maybe small signs.

Bridge To Nowhere?

The most famous bridge of this campaign season, the proposed bridge to Gravina Island,  has been used as a symbol for forward leverage buyout activity — non-existent.  Given the lack of debt availability who could blame some from drawing this conclusion.   Long short, I’m not buying it.  At least not totally.  I don’t expect numbers to be strong mind you, but there will be deals that will get done, especially at the lower end of the market.  There are enough of the following combination’s, that will keep wheels from grinding to a halt (or the well going dry) assuming business performance continues to the positive side, and in certain verticals it will:

> Solid local company + Regional private equity fund + Regional lender

> Solid local company + National private equity fund + Lender who is also a limited partner

> Solid small company + All equity sponsor (I’ve found more than a handful of these in existence)

> LBO firms who will take the re-levering risk

> Debt availability through asset based facilities and mezzanine lenders

Further, there are some really smart folks working in mega-fund land.  I suspect they will find ways to self fund, either directly or through a keiretsu, if the contraction is prolonged.  These are not patient fellows, based on my historical experience.  That said, the institutional loan backlog, which was $50 billion in September, will not clear anytime soon.  Further, we need banks to work through their self confidence issues, and start lending to one another.  It will also take time for government provided liquidity to work its way through the system.  Lastly, seller valuation expectations will also have to re-set.  This leads me to conclude that we will be barren for the next 3 months, but the wheels will get churning again soon thereafter.  In the meantime there will be a trickle large enough to sustain the system.

Not Exactly Bargain Basement

The remaining large inhibitor is the reconciliation of valuation between buyers and sellers.  At the highest level, limited partners are going to cut allocations to private equity funds if they feel the potential rates of return are falling relative to their risk profile.  As such, funds will not cede ground to sellers, but rather try and enforce lower valuations upon entry.  If you are a business that does not need to sell, you are likely going to take a wait and see approach.

The again, maybe you won’t.  Why would that be?  First, you are concerned about the change in capital gains treatment that the election might bring about and since your cost basis is so low, this may overwhelm your concern about hitting a high water mark on valuation.  Second, you might be willing to underwrite part of the transaction using seller subordinated financing, and in doing so still hit a reasonable number against a backdrop of uncertainty.  Third, you are facing an expiration of your debt agreement, whose renewal is no  longer a forgone conclusion.  If you wait until you are up against a cash wall, your valuation will decline precipitously, so it might be better to sell from a position of equilibrium, as opposed to one of weakness.  Fourth, you can recapture value lost today through an earnout structure into the future.  Assuming you are willing to wait and take the risk, this appears a viable alternative.  Finally, you just are not ready to cowboy up and ride your pony for another five years, when the next cycle may be upon us.

While the above may not be compelling to the broadest swath of potential sellers, a subset of those issues resonate with nearly everyone I have encountered recently.  While purchase price multiples will likely remain, on average 2.5x – 3.0x below their peak of 9.3x in 2007, mechanisms for bridging valuation will be found.

Against a back drop that seems to get more cloudy every day, I offer you a ray of hope, maybe a fleeting one. Tomorrow begins the new dawn, hopefully.


Bailout or no-bailout, statistics are trickling in as to how bad the lending environment is for middle market companies, especially those who have Earnings Before Interest Taxes and Depreciation (EBITDA) of less than $10 million.  You see, businesses need capital to fund growth and working capital.  This capital can come from internal sources, cash flow, or external sources, debt or equity.  Since debt is the cheapest form of capital it is the preferred vehicle.  The U.S. business economy depends on the availability of debt capital at a reasonable cost and associated terms and conditions.

If you have been following the headlines, or even if you haven’t, you are likely to be aware that the state of our banking system is in disarray.  Net net, banks do not have sufficient assets net of anticipated loan losses to enable new lending activity.  No debt, no economic expansion, no economic expansion,  no corporate profits, no corporate profits, no job creation, bad things.  This harsh reality is unlikely to come to bare as some form of bank rescue package will be realized.  The political risk of leaving the situation to the free market is just too risky for either party, election year or otherwise.  And thus far, I’ve said nothing about the transaction environment.

Against this backdrop there has been a precipitous decline in the amount of lending activity.  A contraction of both capital sources and products have left businesses hamstrung.  Issuances have decreased markedly.  Syndication has become increasingly difficult as hold sizes are rarely exceeding $25 million.  Cash flow loans are non-existent as asset based financing (ABL) becomes an increasingly large percentage of loan value.  Mezzanine financing has become a critical tool in the leveraged buyout capital structure as equity as a percentage of total capitalization has reached an all time high.

Loan volume in the middle market was a mere $4.6 billion in the first half of 2008.  At this pace, we will likely not crest the levels seen in 2001 ($11.9 billion), the  previous low of the last 10 years.  While the credit markets seemed to stabilize in the spring, the downturn in the economy reversed all gains made.  Lenders have become increasing vertically market focused.  As such, certain out of favor industries, such as building products and transportation, have see loan volumes akin to zilch.

In light of declining credit quality, it is no surprise that loan volume has dried up.  While loan default rates, thus far pale in comparison to 2001 (3.25% vs. 8.25%), they have spiked off a low of 0.4% seen in January 2008.  With respect to bankruptcies, 4.2% of issuers with outstanding payments are now in bankruptcy vs. 1.2% in 2007.  The percentage of leverage loans in payment default or bankruptcy, currently stands at 2.0% far below the 10.0% peak levels of 2002.  We expect to see a narrowing of this gap.

Sources of capital have decreased, and as a result cost of debt capital has increased, in part due to less competition. Leverage multiples have natually declined as well.  There has been a 37% decline in the number of funding sources from 2007 to June 30, 2008.  Fewer lenders, means less competition, and in some cases vacated markets.  Notably the senior debt landscape has changed dramatically.  Cash flow loans for sub $10 million EBITDA companies are gone.  Syndicated deals include market flex language, meaning terms and conditions are not set until the deal is fully clubbed.  Amortization schedules have accelerated with increasingly tight covenant packages for those who are able to attract cash flow based loans.  Senior debt multiples have fallen to 2.8x, down from a peak of 4.7x in 2Q07.

An absence of cash flow lending, has seen a resurgence of ABL.  ABL currently makes up approximately 15% of total loan volume, nearly 6% higher than levels previously seen.  Liquidity exists assuming collateral availability.  That is not to say it is easy money, as advance rates have contracted from historical norms.  Pricing has increased but remains 200 – 250 basis points below cash flow loans.  Fee structures have become increasingly prevalent to offset origination risk.   Asset lite firms, such as service businesses, have been unable to turn to ABL as an alternative.

Cash flow lending is plentiful relative to second lien financing, which is no longer a realistic option for middle market companies.  The advantage of second lien relative to mezzanine debt has been reduced to zero.  Second lien pricing in some cases exceeds that which might be available through mezzanine providers.  Second lien financing is now only seen in large transactions and commonly funded by hedge funds and special purpose entities.  Meanwhile mezzanine availability has increased.  Deals are pricing at between 13% – 17% based on size, with closing fees averaging 2.0%.   Paid-in-kind coupons tend to range from 2% – 5%, with an average of 4%.

A summary of indicative terms in the market (A = Sub $20 million EBITDA, B = $20 million + EBITDA)

> Senior Debt Multiple/Total Debt Multiple – A) 2.5x – 3.0x / 3.75x – 4.25x,  B) 2.75x – 3.25x / 4.0x – 4.75x

> Pricing – A) 1st Lien ~ LIBOR + 450 – 500 bps / Mezz ~ 12% Cash, 4% – 6% PIK, B) 1st Lien ~ LIBOR + 450 – 500 bps / Mezzanine ~ 12% Cash, 2% – 4% PIK

> Amortization – A) and B) 1st Lien ~ 5% – 10% annually, 2nd Lien ~ Bullet, 50% – 75% Excess Cash Flow

> Equity Capital – A) and B) Minimum of 30% and 40% on average

On the transaction velocity front, equity as a percentage of total capital in leveraged buyouts is at an all time high, totaling 42.2%.  Funds, we assume, plan to relever their portfolio companies in the future.  Average purchase price multiples for sub-$50 million EBITDA companies has fallen a full two turns to 6.4x from 1Q08 and almost three turns from the peak in 2007.  Transaction volume, as you would expect is off, way off.

Net net, the current market is leading to broader capital recruitment processes in the search for cost effective debt capital.  Out of favor industries are left stranded, for the moment.  Absent a strong deal sponsor, deals in favorable industries are having difficulty reaching conclusion.  Due diligence processes have been extended in scope and duration.  Club deals are the norm and asset based deals are a companies first option.

In my next post, I will postulate what the future holds for the middle market transaction environment in light of the above statistics.


(information courtesy of Standard & Poor’s)