With continued uncertainty tied to Brexit, China Trade, Fed tightening and gridlock on Capitol Hill, many are finding it difficult to remain confident in the protracted economic recovery. Despite headwinds, the market shook off the December correction, and capital markets remain highly liquid (despite Treasury’s efforts). The below summary from SPP Capital Partners can be viewed in full here: http://sppcapital.com
Two themes dominated the narrative in the private market in 2018:
(1) The sheer magnitude of capital in the private market competing for assets (which had profound effects on pricing, leverage metrics, covenant protections, and the definition of “Adjusted EBITDA”); and
(2) The mounting fear that the US economy is in the last chapter of the longest recovery in its history and that a recession of some proportion is inevitable within the next 6-18 months.
While the first theme drove deal economics through Q4 2018, the second topic has moved to center stage and is increasingly impacting the way institutional investors scrutinize credit, allocate capital to certain sectors, and structure deals. Recent volatility in the equity markets and the reallocation of capital to safer harbors will most certainly impact private market activity and transaction metrics in early 2019. The recent downturn in BDC share prices and growth in commercial bank loans are only the latest evidence of a market going increasingly “risk-off”.
Minimum Equity Contribution
With an increased focus on downside protection, lenders are likely to avoid thinly capitalized deals, especially for sub $10 million EBITDA borrowers. Aggregate minimum of 40% base level equity (inclusive of any rollover) is required for most deals. As leverage levels creep up in excess of 5.00x, 40-50% cash equity (exclusive of rollover) is required. Most lenders discount rollover equity in excess of 20%.
Equity Investment and Co-Investment
Liquidity for direct equity investment (and co-investment) is still quite robust among insurance companies, family offices, credit opportunity funds, and select SBICs. Most traditional mezzanine funds will also provide up to 20% of their aggregate debt commitment as an additional strip of equity. Capital to support independent sponsors is at an all-time high, with new funds created exclusively to support independent sponsors. Promotes and carry will vary depending on the role the sponsor plays post-closing and how much, if any, of their own equity is deployed. Most carry provisions will contain performance contingencies to enhance the initial promote. While structures differ based on the circumstances of each deal, most investors are willing to sacrifice some yield for the liquidity preference.
Recap Liquidity
Recap liquidity is strong, with lenders making little distinction between accretive (acquisition) and non-accretive (recapitalization) uses of proceeds; however, sponsored transactions will achieve higher leverage and better pricing for recapitalizations. After declining between 2014-2016, dividend recapitalization activity increased in 2017 and continued to track upwards in 2018 to a four-year high (approximately $30 billion for the year).
Story Receptivity
While story receptivity remains high, it is increasingly becoming more “sector selective.” Challenged issuers in more cyclical sectors deemed most vulnerable to macroeconomic volatility are more likely to receive higher pricing, less leverage (i.e. one turn less of EBITDA) and potentially, some equity upside incentive features. The general feeling in the market is that we are near the end of the current credit cycle, and lenders will stress test more marginal credits against less generous macroeconomic conditions.