Last in the series I had been working, which you can download it here.

The contraction of the U.S. economy has resulted in upheaval in the middle market transaction environment. Both private equity and strategic buyers are facing challenges in getting deals done. That said, we believe the popular press has gone too far in their characterizations in an effort to remain relevant.

While we see 2009 as a challenging year at best, opportunities remain available to attract capital and achieve liquidity for shareholders. The capital markets are not closed and M&A is not dead. That’s not to say that everyone will enjoy the same alternatives.

In the final piece of our three part series, we provide insight into the deals that will get done in 2009 and how companies can best situate themselves to take advantage of those opportunities. In short, this is an availability of capital market, not a cost of capital market.

/bryan jaffe

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)