arrowAs most of you are well aware, the pet industry is in fact quite large.  Depending on how you measure industry size, the pet industry is the fourth largest consumer segment of the U.S. economy (excluding health care).  And where there are large market opportunities, logically, they are capital inflows from investors, both public and private, seeking to create wealth from changing dynamics in those markets.   As an example, if you were an investor in PetSmart’s public shares over the past five years, you have enjoyed a handsome return from the specialty retail chains’ ascendency, as consumers spent more on their pets as part of the broader humanization trend.

Pet companies have also received a considerable amount of interest from private equity funds seeking to capitalize on the growth trends inherent in the industry.  While I do not have purview into every equity funds predilections, I have yet to come across a consumer oriented growth equity or buyout fund that does not have an interest in the pet space.  Many of them long to replicate the success of Eagle Pack Pet Food, Old Mother Hubbard and Banfield Pet Hospitals.  This “professionalization” of the industry has been a thematic I have waxed on about at length in my prior reports.

However, despite the size of the opportunity and the amount of available capital seeking that very opportunity, private equity transaction volume in the pet industry has in fact been quite limited.  To put this in perspective, according to the Pitchbook platform, there were 364 private equity transactions completed in 2012 that involved consumer facing companies.  Of that deal volume, the pet industry made up just over five percent of private equity deal volume with 19 reported transactions.  The is a decline from the past three years, where pet industry transaction volume made up just over seven percent of total consumer transaction volume.  The chart below tracks the trend over time (source: Pitchbook).

GraphThrough April 2013, there have been six reported private equity investments in the pet industry, putting the industry trend at risk for a second consecutive deceleration.  So what gives?  A few thoughts based on my experience.  First, the interest of private equity in the industry does not align well with the size of its participants.  As a general rule, private equity firms target companies with at least $5 million in Operating Income, with a strong preference for more.  That is not to say that growth equity and buyout deals don’t get done involving pet businesses of every size, but the core interest from these investors is in companies with a strong track record of profitability.  The pet industry has a limited number of companies that fit this mold, with most businesses being bigger or well below that threshold.  Second, there is an active consolidator market in the industry which is a headwind for private equity firms to get a deal done.  If a seller can get a better valuation from a strategic, they will often bypass the private equity market all together and wait to do a strategic sale. Finally, the interest of private equity in the space tends to be disproportionately oriented around pet food and veterinary clinics. A lack of opportunities in these segments has increased focus on retailers, distributors and, more recently treat companies, but a historical sector bias has certainly limited deal volume.

I remain long term bullish on private equity and the pet industry, but, as evidenced by the above, the relationship between the two has some inherent complexity.  However, as private equity gets a track record of success in a broader segment of industry sectors look for the industry to embrace outside equity more fully.  Deals beget deals.

/bryan

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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

Despite its size, the pet industry, as a whole, is under analyzed.  That is not to say there is a lack of analysis, but rather a lack of diverse perspectives.  The reason for the homogenous set of  “points of view” is largely structural.   There are a handful of very big companies that drive the pet industry from the product side — Mars, Nestle SA, Procter & Gamble, Del Monte, etc.  However, we have limited transparency into the granular performance of their pet brands because they either have no reporting obligation (Mars) or their pet business is quite small relative to their overall income statement or balance sheet.  Notably Nestle, who controls some 30% of the pet food business, does not report  its pet food segment separately.  The same can be said about pet retail — Petco, Petsmart, Wal Mart.   The primary industry reporters — Packaged Facts, Mintel, IBIS — rely, largely, on the same survey methodology.

Given the above, you can understand why I was excited to get my hands on Todd Hale’s “State of the [Pet] Industry 2011”.   Todd is SVP, Consumer Shopper Insights for The Nielsen Company.  Simply put, I think Todd brings a different and unique perspective to the table.  Because his firm has access to unprecedented amounts of transaction data, he is best situated to look at the industry from a consumer standpoint, as opposed to from a product or individual retailer standpoint, and of equal significance, put pet consumer behavior in the context of consumer behavior in other retail environments.

With that as my long winded set up, here are some key takeaways from his presentation (all data credits to The Nielsen Company):

  • The Polarized Consumer.  We often talk about consumers in terms of median household income.   One can then analyze consumer behavior across stratified income bands.  This is really nothing new.  But what Nielsen scan data (actual product movement and basket purchases) provides is the opportunity to, on a rolling 52-week basis, analyze purchasing behavior within these income bands and compare the results to prior year periods.   This data does not need a +/- 4% confidence interval because it relies on actual transactions, as opposed to sentiment.  What Hale’s data shows is that the consumer population is very polarized.  While the wealthiest 20% of the consumer population have exited the recession, as evidenced by growth in shopping trips and shopping dollars, all other income bands have contracted.   This demonstrates the fragility of the retail industry and validates how important the premium demographic is to the health of all retail, not just pet.   Using the same methodology, Hale shows that that the affluent (those with household incomes in excess of $70,000) purchase 40% of the pet food and consume 42% of the pet services, despite making up less than a third of the consumer population.   As a result, it is easy to conclude that the pet industry remains as vulnerable as other retail categories.
  • Pet is En Fuego.  If you look across U.S. retail formats, as measured by store counts, value and convenience are winning.   The number of warehouse clubs, supercenters, dollar stores, supermarkets and convenience stores have all increased since 2005.  Only drug and mass merch have contracted.   However, when you dig into the specialty retail category, home improvement and pet have shown meaningful store count growth during this same period, with pet doors increasing 43% and home improvement moving 10.5% to the positive.  Further, pet is the only store category that has shown positive household penetration over the past 10 years, increasing from 30% to 32%.   In short, pet specialty industry has been star performer in the retail landscape over the past six years.
  • PetSmart is More En Fuego.  We have covered the performance of PetSmart on this blog in some depth.  Our historical analysis demonstrated that once PetSmart stopped focusing on topline growth and embraced a balanced scorecard (same store sales, product level gross margin, earnings per share) it quickly became the premier retailer in the pet industry.   Hale puts PetSmart’s performance in perspective across all retailers, noting that PetSmart has produce a 14 quarter “winning streak” of positive comp store sales.   Nordstrom came in second in the discretionary spending category at six quarters.  Among all other retailers (discretionary, value, club), only Sam’s Club and the “dollar” stores (Dollar Tree, Family Dollar, Dollar General) have comparable winning streaks, with only Family Dollar and Dollar General having higher average comp store sales since 2008 than PetSmart.  While the bar for domination of the pet specialty channel is in fact low, Hale’s data proves how impressive the company’s performance has been relative to all retailers.
  • Inflation is Hurting/Helping Pet.  Based on Nielsen scan data for the past two years, prices have risen across the board, with the exception of alcoholic beverages and pet food, though pet food prices increased over 4%  in 2011.  Pet care and pet treats also experienced inflation of 2% and 3% respectively in 2011.   While inflation is hitting consumers at times when incomes are down, price increases have helped the pet industry grow to new heights (sort of perverse).  Notably, Hale’s data shows more pet industry inflation than PetSmart has reported, meaning price increases at grocery and mass have been more substantial than in pet specialty.
  • Brands Hang Tough.   The recession kicked off a new chapter in the branded versus private label tug-of-war across consumer categories.   As Hale points out, private label brands hovered at 19% – 21.5% of unit volume from 2005 to the middle of 2008.  During the recession, store brand volume shot up and has remained at 21.5% – 23.5% post-recession.   Since 2007, store brands have grown 21% in dollar volume versus 3% for branded items.  Notably within pet, all major categories have a lower penetration of store brands than the product average, and private label penetration has fallen in pet care, food and treat over the past year.   This is logical given that store brand attachment falls as income rises, and the pet industry is driven (per above) by the higher income demographics.

In summary, Hale’s data provides us a different lens through which to view the pet industry.   The dominant perspective, to date, has been that of the product provider, and we are led to believe that the manufacturer dictates to the customer what he/she wants and consumes.  Hale helps us understand that the tail may in fact be wagging the dog — consumer behavior, and the ability of pet retailers to incent that behavior, may have been the more powerful force in driving the growth of the industry over the past five years.

/bryan

The private equity community has taken a modest fascination to the pet industry over the past five years.  While investment in the pet industry is nothing new – Thomas H. Lee Partners acquired PETCO Animal Supplies, Inc. in 1988 – interest accelerated markedly in since 2007.  According to the Pitchbook Platform, 46 investors had completed investments in 44 pet related companies over the past five years.  Further, pet industry deal volume grew from 2009 – 2010, from seven to 11 deals, in contrast to the broader consumer marketplace which contracted.  From a transaction volume standpoint, 2011 is off to a strong start for the pet industry with five announced deals in January to-date.

Pet food and treats have been the source of a large percentage of this transaction volume.  Given the growth in the pet population and the percentage of owner spend target towards consumables, it was relatively easy to see why these properties would experience tangible growth.  Further, the proliferation in channels where pet food and treats are sold coupled with the increased willingness of consumers to spend on premium pet food have pushed the category to impressive heights.   The net result was there were nine major pet food investments/acquisitions in the 2007 – 2011 timeframe.

Of the major acquisitions and investments the two most talked about transactions took place prior to the recession.  In October 2007, Swander Pace Capital, a California based consumer oriented private equity firm, sold Eagle Pack Pet Foods, Inc. for an undisclosed amount to Berwind Corporation.  Swander Pace made its initial investment in Eagle Pack in 2004.   Monies were used to drive sales and marketing and to acquire additional talent into the business.  In August 2008, Berwind followed up its Eagle Pack acquisition by purchasing Old Mother Hubbard, Inc. for $400 million from Catterton Partners, a Connecticut based consumer oriented private equity firm.  Like Swander Pace, Catterton had made its initial investment in Old Mother Hubbard in 2004, to drive sales and marketing, investing $45 million for an undisclosed ownership percentage.   Berwind went on to combine the two brands to form WellPet, LLC, which is an active consolidator in the pet food/treat space today.

Little was publicly disclosed regarding the transaction multiples associated with the buys outlined above.  However, general consensus was these transactions took place in the range of 2.5x – 3.0x latest twelve months revenue.  The relevance of those multiples was established a year earlier by Del Monte Foods Co. in its acquisitions of The Meow Mix Company, LLC (3.7x latest twelve months revenue) and Kraft Foods Inc., Milk Bone Dog Food Business (3.2x latest twelve months sales).  Subsequent pet food/treat deals have all involved a comparison to this multiple set and collectively they have formed the basis for seller expectations thereafter.   Notably these multiples are consistent with branded consumer goods companies during the same period.

While seller expectations in the pet food/treat space have remained anchored in the past, the general transaction market has undergone significant turmoil.   A collapse of the debt market rendered private equity dormant for much of 2009 – 2010, with market activity bottoming in 2Q2009 and only modestly recovering over the next 18 months.  Without private equity as a foil, public company buyers felt less challenged to pay a premium for attractive properties, and valuation multiples contracted.  The net result is a number of pet food/treat deals have died over the anchoring on these historical multiples.  In short sellers’ expectations have not changed with the times, in part due to the belief that the pet industry holds a sacred place in the consumer transaction landscape, a notion that has received considerable validation.

According to the Swander Pace website, the private equity fund recently closed on a new pet food platform acquisition, acquiring Merrick Pet Care, Inc., a manufacturer and marketer of wet and dry dog and cat food under the Merrick, Before Grain and Whole Earth Farms brands.  While there has been no deal announcement to date (one does not appear imminent consistent with the Monitor Clipper/Highland Capital Partners/Castor & Pollux transaction of 2008) and transaction value and associated multiples have not been disclosed, the data points we are hearing, validated by several sources, point to a significant contraction relative to the multiples above.   My opinion is that the sale of Merrick Pet Care will mark a meaningful bifurcation in pet food/treat transaction multiples.  This parsing of the market is just what private equity has been hoping for in order to unlock transaction volume in the pet industry.

The above is not to say that premium multiples for pet companies are no longer available.  In fact, there is ample evidence, based on the Natura Pet Products, Inc. and Waggin’ Train, LLC transactions, that the 2006 – 2008 data set remains relevant, but no longer are we looking at a one size fits all world in pet food/treats.  Rather, premium multiples will be reserved for deals with characteristics common to premium deals in other consumer markets – brand awareness and value, operating leverage and economies of scale, defensible intellectual property, and proven management.  Large multi-brand properties that command significant shelf space across multiple sales channels will be the beneficiary of these valuations.

From time-to-time I expect emerging companies with truly innovative products and defensible market positions in the pet industry to command premium multiples, even in excess of those outlined above.   Companies that meet this criterion will (a) have products that can be sold across the pet channel spectrum, in general mass, and in specialty retail environments, (b) meet an emerging need that is not well addressed by existing alternatives, rather than being a new twist on an existing formula, (c) solve a long term structural industry problem that impacts cash flow, and (d) be lead by management teams with proven industry experience.   However, for all intents and purposes, the axis of the pet transaction world was effectively bent by the Swander Pace/Merrick Pet Care transaction, and possibly for the better of total transaction volume.

/bryan

2010 was expected to be a blowout year for liquidity transactions among privately held lower middle market companies.   A modest economic recovery coupled with a significant private equity capital overhang and looming capital gains changes gave many owners the belief that conditions were reasonable enough to warrant a dialog with buyers.

Through the first half of 2010, domestic mergers and acquisitions experienced a near 200% year-over-year increase and the market was on pace to reach levels not seen since 2000, according to Dealogic.   However, private equity deal volume (a significant sub-set of overall M&A and a barometer for the broader market) fell in the third quarter, according to the Pitchbook Platform, as fears related to changes in the tax code dissipated leaving us to wonder if the year had fizzled.  Based on fourth quarter Pitchbook data, private equity rebounded nicely, as 376 private equity deals closed, the second best quarter in the past two years.   For the full year, private equity transactions volume rose 9% relative to 2008; a modest but material improvement.  Based on announced strategic M&A, we expect those full year figures to also come out favorably when published.

As the calendar turned, transaction professionals began looking for signs as to how 2011 might break.  Based on January private equity data it looks as if we are off to a strong start.   Through the first three weeks of the year 114 private equity transactions totaling $8.35 billion closed, according to Pitchbook; the best start to the year since 2000.  The question that remains is whether this deal volume represents deals that missed year end deadlines or conditions are in fact that favorable for sellers.

From the pet industry perspective, 2011 is off to the best start on record.   Today’s announcement brings January-to-date figures to five major private equity/debt backed deals (buyer/target):

January 24, 2011 – WindPoint Partners / Petmate (terms not disclosed)

January 7, 211 – PNC Mezzanine Partners / Pet Partners ($21.5 million mezzanine debt financing)

January 7, 2011 – HIG Capital / Pro-Pet (terms not disclosed)

January 6, 2011 – MidOcean Partners / Freshpet (undisclosed equity investment)

Unannounced – Swander Pace Capital / Merrick Pet Care (terms not disclosed)

Notably, these transactions span a number of major segments of the pet industry — food (3), hard goods,  and veterinary care, the later of which had been rather dormant over the past 24 months.    Further, within food you have the gamut of contract manufacturing, branded, and raw/fresh.  Diversity, in my opinion, is a sign of health.

According to Pitchbook, 46 investors had completed transactions involving 44 companies in the pet industry since 2007.  They put 2010 transaction volume at a 11 transactions, relative to my count of 13 private equity backed deals (both of us exclude angle capital backed transactions).  If January is an indication of what is to come, I would estimate that 2011 could bring us 20 major industry deals sponsored by private equity backers.   However, with the announcement of the Petmate sale, the majority of the known backlog has been cleared.  Only a stronger economic recovery, coupled with a better valuation environment, could push us to those levels.   Undeterred, I expect private and growth equity firms to continue to scour the landscape for deals.

While little has been disclosed about the above deals, the Swander Pace / Merrick Pet Care transaction is notable.    It is my understanding that the transaction multiples associated with this deal represent a significant departure from the multiples associated with key transactions in the 2007 – 2008 timeframe.   Look for an article on this subject from me in the March issue of Petfood Industry Magazine.

/bryan

(p.s. the picture at the top is the basic Newtonian Physics proof for velocity)

 

For those of you who are not avid followers of the leverage buyout transaction market, or readers of the Wall Street Journal, it may come as news to you that on November 25th, while you were likely in a tryptophan induced stupor, a private equity consortium agreed to take Del Monte Food Co. private in a transaction valued at slightly more than $5 billion.   The buying group included Kohlberg Kravis Roberts  & Co., better known as KKR, of RJR Nabisco fame, among other notable transactions.   Both these fact will become important later.  KKR was joined in the transaction by Centerview Partners Management LLC and Vestar Capital Partners.   This fact has no relevance going forward however.

In and of itself a transaction involving Del Monte is hardly notable.   In fact, KKR was once the owner of Del Monte.   The company was one of many brands under the RJR Nabisco umbrella that was sold off, for nearly $1.5 billion, to pay down debt in the early 1990s.  The buyers later sold the business to Texas Pacific Group for $809 million in 1997.    In short, Del Monte has been around the transaction block and therefore news of a deal should not be “above the crease” material in and of itself.

Further, when you think of Del Monte you likely think of canned pineapple, or at least I do.   After all Del Monte is a sacred American brand in the field of shelf stable food products.  The company’s Consumer Products segment manufactures, markets, and sells branded and private label fruit, vegetable, tomato, and broth products under the  Del Monte, Contadina, S&W, and College Inn brands, among others.   The company sells its products through direct sales force and independent food brokers to grocery, club store, supercenter, and mass merchandiser customers; dollar stores, drug stores, convenience stores, military, food ingredients, and private label customers; and the foodservice industry.  Exciting I know.   Hang on, it gets more interesting; I promise.

Now consider a few things that I contend are not coincidences, and represent the real impetus behind the transaction:

1) In March 2006, Del Monte purchased The Meow Mix Company, LLC, a manufacturer and marketer of cat food and cat related products, from a private equity consortium for $705 million, or approximately 2.8x revenue.   In July of the same year, Del Monte acquired the Milk Bone Dog Food Business, maker of dog biscuits and chew treats, from Kraft Foods, Inc. for $580 million, or approximately 3.2x revenue.   All told $1,285 billion in deal consideration for approximately $433 million of pet related revenue.

2) As of May 2010, sales from the Pet Products business of Del Monte on a latest twelve months (LTM) basis were $1.75 billion, or 46.8% of total revenue.   More significant, Earnings Before Interest Taxes and Depreciation (EBIT) for the Pet Products business  on an LTM basis were $355.5 million, or 70% of total EBIT and 61.4% of total product EBIT (backing out corporate overhead).  In short Del Monte is a pet company from a profit standpoint.   Applying an 8.0x multiple to these profits yields a valuation of $2.84 billion or 57% of deal value. [post publishing note: In their analysis Deutsch Bank valued the pet business at 11.0x, which would mean the pet business constitutes over 75% of deal value]

3) In January 2010, KKR purchased Pets at Home Ltd., the largest pet retail chain in the United Kingdom for $1.55 billion.  Del Monte only derives 6% of total revenue from foreign markets.   In short, KKR has been bitten by the pet bug in a significant way, and its Pets at Home acquisition provides an immediate outlet to increase foreign sales of Del Monte brands.

Net net, this deal was not about canned goods, it was a bet on the macro pet market.  The Del Monte acquisition, when closed, would constitute the second largest consumer focused pet deal on record, after Nestle S.A.’s $12.1 billion acquisition of Ralston Purina Company in 2001.   What happens from here remains to be seen.  It’s hard to believe the buyout firms won’t separate the two businesses in an effort to unlock further value, but there’s no guarantee.   A standalone Del Monte Pet Products business could go public at a premium multiple in favorable market conditions.

/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