By Mike Barnes, December 13, 2016 When arranging debt for a company, the first question is: “What is right for the business?” That may seem obvious but few people ask it. Instead, they start with what is available or what has been done before. Knowing the answers to these two questions is bread and butter for a debt finance adviser, but they do not determine what is possible. If the business needs the debt to be structured in a certain way, it can be tailored to work that way – there is so much more to it than the most debt for the lowest price.
You may be wearing your suit and tie when you meet bankers, but you do not need to go down on bended knee. There is plenty of liquidity in debt markets and plenty of options for mid-market companies. Before the financial crisis jumbo deals were financed with lunatic leverage, 7-8-9-10 times EBITDA. Even in the mid-market, deals were getting 5-6x. You can’t get that now, and to be frank, you probably wouldn’t want it.
Since the crash there has been more discipline in leverage terms. Everybody’s gone back to the textbook: senior debt is what can be repaid from cash flow and mezzanine is the slice in the middle that is reliant on an exit or refinancing event to get repaid.
More pools of capital
The big development over the past decade is the rise of debt funds. I wrote to 26 debt funds asking them what they had lent in 2014-15 and got data from 19. Not perfect, but nonetheless a real insight into activity levels in this private market. More than £6.1bn of debt had been provided to over 100 UK mid market PE transactions, backed by more than 60 different PE firms. Within five years, I estimate 80-90% of mid-market debt will be provided by funds.
Why have the banks lost this market? Their biggest problem is that they want repaying more quickly than debt funds. Bank debt is widely available and you can get 3-4x leverage at a 4% margin, while a fund will do 5-6x at a 7% margin. Bank debt looks cheap, in a simplistic sense, attractive until you remember that banks want regular principal repayments as well. If you are a growing business – and if you’re considering private equity you’d better be – then you need to preserve your cash flow for working capital, capex and maybe acquisitions. The interest rate is not necessarily the most important thing when considering what is right for your business.
In the driving seat
Funds ended up driving the debt bus because as passengers they were losing out, particularly in restructurings and refinancings. Many started life as mezzanine funds and found that they were powerless in restructuring situations, squeezed by equity and senior debt and with no voice.
The funds took control by providing substantially all of the debt in a structure, and as a result get more control of recoveries when things turn sour. Banks are still on the bus, providing a ‘super-senior’ layer of up to 1x leverage. They get looser covenants and few enforcement rights, but their money is so lowly geared that the risk is minimal (the fund can only recover their investment after the super-senior lender is repaid in full) and it gives them a foot in the door to win lucrative ancillary business. One might argue that equity is the loser in this “new” structure, but the reality is that they are protected by the fact that the overall structure is more robust.
Plenty to choose from
There are a lot debt funds and their numbers are growing every year. So, who should you go with? Essentially funds can be grouped into those that are established and those that are not. An established fund has a track record of completing transactions and raising more money from its investors. An established fund can follow your company as it grows. A newcomer may be able to, but it is an additional risk.
You should also choose those who can price the debt flexibly according to the risk, particularly if you don’t want the maximum leverage that may be on offer. And you certainly don’t want to ignore new funds. For instance, there is a new fund raised with backing from an insurance company. It has a lower return target than rates targeted by established players, who may be contractually restricted from lending at lower rates. Some newcomers are identifying that pricing flexibility, more than maximum leverage, is what the market needs.
Bank debt or fund debt may not even be what you want. Asset-based finance has made huge progress in recent years and is no longer just the “lending of last resort”. Arranging debt finance comes back to my first, apparently obvious, question: “What is right for the business?”
If you would like to talk about how any of these issues relate to your business then please get in touch – mjbarnes@wyvernpartners.com