Continuing the rapid expansion of 4Q20, middle-market M&A activity is expected to remain on the upswing through 2021. Private equity firms, previously focused on stabilizing existing portfolio companies adversely affected by COVID-related headwinds, have returned to growth mode in full force. This significant pent-up demand coming out of the 2020 trough spurred numerous first quarter revivals of previously sidelined executions.
Further catalyzing growth is the continued strength of PE fundraising efforts, resulting in a record-setting $2+ trillion of bullish PE dry powder ready to be deployed. The first quarter also saw an unprecedented $97 billion of SPAC capital flood the market via nearly 300 IPOs (already outpacing the whole of 2020). All forces at play are bolstering trading activity, driving fierce competition across all sectors, and propping up valuations.
Per Refinitiv, the average LBO purchase price multiple reached a new high of 12.3x in 1Q21 (up from 11.8x in 4Q20). Further, 67% of LBOs cleared the market at or above 10x valuations, representing the highest share on record. Of course, increasing purchase multiples do not necessarily garner dollar-for-dollar increases in financing appetite. Middle-market leverage capacity in the first quarter tapped out at an average of 5.2x, necessitating an average 58% equity check, perpetuating the higher blended cost of capital that has prevailed over the previous year.
IN THE FACE OF TODAY’S UNPRECEDENTED COMPETITION, THE PREVAILING QUESTION BECOMES: HOW CAN A BUYER ‘WIN’ THE DEAL WHILE STILL DRIVING VALUE?
Outside of paying hefty premiums for quality assets, one way that buyers have managed to edge out competition is the promise of speed. Transactions that have historically closed within realistic timeframes of ~6 months from start to finish are now closing at a breakneck speed of ~90-100 days.
For ‘premium’ quality assets, buyers are taking aggressive timelines a step further, preempting the process in an effort to shut down competition prior to a full sell-side launch. PE groups that have a proven strategic interest, can be decisive, and are armed with committed financing / supportive lenders, can have a transaction under exclusivity within 2-3 weeks, providing the sellers with an expeditious closing.
Certainty of Funds
While a preemptive bid is always an attractive route, a seller’s willingness to shut down a competitive process – even for a market clearing valuation – will be fully-predicated on their perception of the buyer’s ability to fund. In a compressed timeframe, the most simple funding option might appear to be an equity backstop.
That said, closing into an over-equitized position with the plan to recap post-closing comes with its own set of financing challenges, including market risk exposure and, if not carefully addressed, lender perception of a less attractive use of proceeds. Said otherwise, the market tends to equate post-close recapitalizations with more traditional dividends, an implication that could negatively impact lender appetite and lead to a more restrictive financing package than could have been achieved out of the gate.
Alternatively, a borrower also has the option to run a debt process and lock down committed financing to fund concurrently with the acquisition. In the uncertain macroeconomic climate that has prevailed over the past year, where traditional bank lenders have cautiously retreated, direct lenders have stepped into the spotlight, employing a multitude of lending strategies that showcase their inherent speed and flexibility in support of the robust M&A market.
Strength of the Private Credit Market
In a widespread show of confidence, middle-market direct lending activity has rapidly returned to pre-COVID levels. Augmenting an already precipitous ramp in healthy deal flow is a wave of more challenged credits, as a slew of previously on-hold executions come off the bench. Per Refinitiv, 1Q21 direct lending volume in the sponsored middle-market totaled over $22 billion, coming in just shy of 1Q20. Of that, just under half (or $10 billion) was for LBO financing, an LBO new issuance volume on record.
This flurry of new deal opportunity is met by an ever-expanding lender universe hungry to put capital to work. Competition for high-quality assets has also resulted in increased leverage tolerance and exceedingly borrower-friendly loan structuring trends. Per Refinitiv, the share of middle-market sponsored deals with total leverage above 5x increased to 47% in 1Q21. Concurrently, Livingstone has also seen a return of many pre-COVID structuring norms, including increased hold levels, reduced contributed equity requirements, acceptance of greater EBITDA addbacks, more lenient restricted payment baskets, etc.
Leveraging the Debt Market to Drive Growth & Returns
Tapping a buyer’s existing lending relationships can be helpful but may not bear quite enough fruit for more complex situations, depending on specific fund mandates and targeted hold levels. Conducting broader lender outreach ensures a comprehensive market read and introduces vital competition to the debt placement process, pushing even incumbent lenders to sharpen pencils and ultimately allowing for optimal (often outlier) outcomes.
That said, what the direct lending market has in capacity and creativity, it often lacks in transparency. It’s no secret that the private credit market can be challenging to navigate, typically requiring real-time knowledge of its vast network of market players and constantly evolving structures. To garner the best outcomes, borrowers need dedicated resources to tap into the private credit market and its myriad of solutions, ‘craft the story,’ and work lenders through hot button diligence issues in an efficient time frame.
As each fund’s credit process is somewhat unique, a strong understanding of the various thought processes and behaviors that drive credit decisions can make all the difference – both at the time of closing, as well as on an ongoing basis when trying to employ operational improvement and growth initiatives (especially those that fall outside the confines of the initial credit document). The efficiency inherent to single-lender and club transactions can become a double-edged sword with respect to post-close concessions and amendments, as the ultimate evolution of the living document is dependent on a limited number of voting parties. As such, it is imperative to think past the initial funding and to secure the right long-term financing partner(s) to ensure streamlined processing of any future accommodative amendments, as well as appetite (and capacity) to fund ongoing growth capex and add-on acquisitions.
The view remains highly optimistic for the remainder of 2021. Even affected credits have started to show consistent performance improvement from the COVID trough, already rolling off LTM EBITDA calculations. Further fueling today’s momentum is wide speculation of substantial increases in capital gains taxes, creating an even greater sense of urgency to get deals done before the sounding bell.
Buyers faced with fierce competition, compressed timelines, and ever-rising valuations will remain under extraordinary pressure to deploy capital and create real value. Especially for financial buyers making platform acquisitions, successful execution in the lower middle-market in today’s climate will be largely dependent on the cooperation of the financing markets.
The debt market is ripe with opportunity for those that know how to access it. Given the added complexity of understanding the full impact of COVID-related performance (both positive and negative), ensuring value necessitates a greater focus on buy-side diligence and deal structuring, often constraining capacity to run a competitive financing process.
Livingstone’s debt advisory practice leverages decades of experience to craft carefully orchestrated processes in support of sponsor and private company financing needs. Our team helps to alleviate buyer resources by acting as an extension of the execution team to provide access to the global debt markets, drive competition amongst investors, and manage deal momentum to enhance overall certainty of closing. We have built extensive long-term relationships with 400+ capital providers, raising $2+ billion of capital across a broad range of industries and credit profiles. With debt advisory professionals across Europe and the US, our consistent volume allows us to stay abreast of current market trends and achieve the best available financing solutions on behalf of our valued clients.