Complex M&A debt markets - handle with care
The debt markets have flourished since the financial crisis. And as banks reined in lending to SMEs, new and different funding options became available to companies looking to expand. But looser terms have prompted warnings that there may be trouble ahead. Vicky Meek asks if we should be concerned.
The past two years have seen a boom in global M&A, with 2018 having a particularly strong showing so far. The first half of the year saw $1.94trn of deals announced across 8,560 transactions – the highest value recorded since the financial crisis, according to Mergermarket figures. Geopolitics is in flux – including trade wars, real wars, and political crises in some parts of the world. But the World Bank says that global GDP growth “will remain robust” in 2018 at 3.1%. For their part, companies appear to be taking that prediction on board, and making hay while that particular sun shines.
Persistent low interest rates are at the heart of this M&A boom and drive for expansion among businesses. Yield-seeking investors have pushed into asset classes such as private equity. Dry powder exceeded the $1trn mark for the first time ever in December 2017. Investors have also moved into private credit strategies, where assets under management broke records, with $667bn held by private debt funds at the end of last year, according to Preqin – a 13% increase on the December 2016 figures. There is clearly a lot of liquidity in the system, and debt funds have boomed as banks reduced their exposure to SME lending.
Against this backdrop, the Corporate Finance Faculty launched a new guideline – Debt for Deals – in conjunction with Clydesdale and Yorkshire Banks (CYBG) earlier this month to help businesses navigate the increasingly complex debt landscape ( ‘Debt for Deals guideline’). “High liquidity and increasingly sophisticated approaches to funding are enabling M&A, refinancing and deals to achieve more expansion generally,” says Katerina Joannou, manager of capital markets policy at the faculty. “Companies have never had so many options when it comes to funding growth.” David Hayers, head of growth finance at CYBG, expands on the theme: “The M&A market remains very buoyant.” He adds: The weight of equity to be invested is driving appetite for deals and is also contributing to increasing prices. That, in turn, is encouraging sellers. Added to this is the strong availability of debt coming from both banks and funds.”
Sky's the limit
Valuations have, in fact, reached their highest levels for 30 years, according to the Q4 2018 edition of the Intralinks Deal Flow Predictor. Globally, the median enterprise value to EBITDA multiple for announced M&A during the first six months of 2018 was over 14x. Perhaps even more strikingly, private equity is paying similar valuations to strategic buyers, which is a significant development given that trade buyers often pay a significant premium for the strategic value of an asset.
But it’s important to keep in mind that these statistics include only announced deals, not those that have gone unreported or merely been rumoured. “Valuations remain high,” explains Chris Lowe, partner in the capital and debt advisory team at EY. “That’s a function of both the demand for good quality businesses, and the fact that lower quality companies aren’t shifting in the market.” Yet at the same time, the amount of debt being used to fund deals has crept up, as competition for business continues to intensify. “I’ve never seen such a competitive market between banks and funds as we see now,” adds Lowe. “The credit funds are largely winning, in terms of attracting intellectual capital from banks and market share. They can write bigger cheques and take more execution risk in the leveraged space.
Some funds are now moving into the corporate space and we’ll see them increasingly target public limited company markets.” The effect of this competition and higher valuations is clear. In 2012, European leveraged buy-outs were funded, on average, with a 55:45 ratio of equity to debt. By 2017 that ratio reversed, according to PwC figures. This increased leverage has prompted warnings from some quarters that risk is building up in the system. And it may not be long before we see how much risk some lenders have taken on. In the UK, a number of consumer-facing businesses – including House of Fraser and Jamie’s Italian – have faced financial difficulty in recent months. “We’re already starting to see evidence of the cycle turning,” says Fenton Burgin, head of corporate finance advisory at Deloitte. “Look at the casual dining space, where a number of well-known names have hit the buffers, in part because of rising interest rates. As interest rates continue to normalise, we will see more of this stress migrating into other sectors.”
The issue of what might trigger distress is up for some debate – Hayers, for example, sees the tightening of monetary policy as less of an issue than Burgin. “Clearly, if interest rates rose quickly, that would have an impact, but that seems unlikely. Central banks are moving cautiously,” he says. But among the interviewees, there is agreement that today’s market conditions are largely untested through more difficult times.
One of the standout features of today’s debt market is the borrower-friendly nature of many of the terms being struck with lenders. A recent Moody’s report, for example, suggested that nearly 80% of leveraged loans today are ‘cov-lite’ (loans with no maintenance covenants, only incurrence covenants) – up from around a quarter in the run-up to the crisis. Many aren’t cov-lite, but are actually ‘cov-loose’, which means they only feature a leverage covenant. Part of the driver for this has been the emergence of private debt funds.
“The rapid expansion of direct lenders, in particular in the private equity arena, has led to a general erosion of the covenant landscape with many deals now cov-lite,” says Burgin. “Overall covenant quality in leveraged loans is weaker today than in 2007 across every risk category.” And it is this particular trend that is causing most concern, as Hayers explains: “Covenants are a good sense check for companies as well as banks, as they provide an early warning of any issues that need to be understood and addressed.” For Burgin, the lack of an early warning system is storing up trouble. “In the immediate aftermath of the global financial crisis, restructurings were primarily bank-driven,” he says. In many cases, there was sufficient lead-time for banks to see covenant breaches coming. Lenders therefore had time to renegotiate terms or find other solutions before default. “Today,” adds Burgin, “because of the weaker covenant protections, by the time a company breaches any covenants, it won’t just have marginally missed the original plan and a cash call might well be imminent.” Lowe says the concern about risks building is justified, as a lot of cov-lite loans are with average to indifferent performing businesses: “Interest rates will rise further, potentially linked to any currency volatility, although there is a case for short-term protection of sterling through interest rates. Those business that are not adequately hedged in their positions may have issues if this happens.”
However, Hayers stresses that these terms are not present across the entire market. “We’re not seeing cov-lite or cov-loose filter down into the SME market,” he says. “By their very nature, SMEs are smaller, and generally less able to withstand significant shocks than the large corporates where cov-lite and cov-loose structures are more prevalent.” For businesses with private equity backing, some argue that the flexibility afforded by fewer covenants could give extra breathing space if they do not perform to plan. “The prevalence of cov-lite and cov-loose is not a particular concern for most private equity-backed companies and, in fact, is likely to smooth the path to better performance,” says ECI managing partner Steve Tudge. “Sponsors would spot trouble early on, and be able to deal with the situation before covenants are breached – these terms give us more time to work on underperformance.”
Private equity firms have now adopted more sophisticated portfolio monitoring tools and practices. Running financial performance reports against typical covenant tests, despite the absence of covenants in loan documentation, allows them to spot trouble ahead that would previously have been flagged by covenant breaches.
Whether that will prevent businesses becoming distressed remains to be seen. But how will the different lenders behave when conditions change? For example, many debt funds have not been in business long enough to have operated through difficult times. “It will be interesting to see how events unfold if we have a downturn,” says Tudge. “A big change from previously is that, in the past, borrowers tended to deal with five or so clearing banks and relationships with these tended to be strong. Nowadays, there are a lot of debt funds and even some clearing banks have debt funds behind them, so it’s harder for many borrowers to forge strong relationships with lenders. We don’t yet know what the consequences of that will be if conditions change.” It’s a point also picked up by Burgin. He says that banks have significantly improved controls since 2008, and are now in ‘super-senior’ positions. “That means they are much less likely to incur the first losses in default situations. As a result, they may not be in the driving seat on any negotiation where funds are the main capital providers.”
The diversity of debt funding sources now in the market means that it’s not just a variance in approach between banks and funds; there could be very different responses to portfolio company underperformance from fund to fund. “If a loan is extended by one of the larger direct lending institutions, for example, the scale and diversification of its portfolio may enable it to suffer some impairment without a significant effect on its broader fund performance,” says Burgin. “These lenders will be able to focus on their reputation and their ability to work with borrowers. That may not be the case for smaller institutions that may be quicker to act to protect their positions by, for example, quickly moving to sell the loan in the secondary market or to another institution.” All of which can mean that companies could find they have very different partners around the table from the ones they originally negotiated with.
Bonds that tie
There is some evidence of pushback among lenders. “Conditions in the debt market have probably peaked in the mid-market, but are still extremely good,” says Lowe. “We are seeing a more cautious and conservative approach to the transaction environment generally.” Yet the next 18 to 24 months are likely to be something of a test for a debt market that has changed almost beyond recognition. There are bound to be some casualties – in both the lender and borrower camps – as conditions shift. One element hasn’t changed – the importance of strong relationships between companies and their lending institutions. “Open dialogue and understanding counts for a lot when things don't go according to plan,” says Tudge. “This is harder when there are so many debt providers in the market, but our approach is to draw on our debt advisers’ knowledge – they know the funds’ track records, and how they react when situations don't go to plan.”
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