The recent yield-inversion sowed a historically evidenced seed of doubt into markets. However, many believe that this traditional leading indicator does not necessarily foretell a coming downturn due to the unprecedented levels of worldwide central bank liquidity and monetary easing. Markets welcomed the most recent jawboning from the White House regarding China trade negotiations. The outcome of the planned October trade meetings, coupled with upcoming Fed actions, will likely determine how 2019 closes out. The below summary from SPP Capital Partners can be viewed in full here: http://sppcapital.com
Minimum Equity Contribution
Anticipating a wind-down of the current credit cycle, the focus increases on downside protection. Accordingly, most lenders are likely to avoid thinly capitalized deals, especially for sub $10MM EBITDA borrowers. A minimum aggregate of 40% base level equity (inclusive of any rollover) is required for most deals, with at least 20%-25% minimum new cash equity being the norm. As leverage levels creep up in excess of 5.00x EBITDA, 40%-50% cash equity (exclusive of rollover) is required. Most lenders discount rollover equity in excess of 20%.
Equity Investment and Co-Investment
With less opportunities on the horizon, and abundant leverage availability keeping purchase multiples at premium levels, interest in independentlysponsored deals is at a high point. This is especially the case when the independent has secured an LOI at sub-auction level pricing. Liquidity for direct equity investment (and co-investment) is robust among insurance companies, family offices, credit opportunity funds, and select BDC and SBICs. 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
Dearth of new deal flow continues to drive aggressive dividend and share recapitalizations for sponsored transactions. In most cases, pricing and terms for “non-accretive” recapitalizations mirror those of more “accretive” uses of capital such as acquisitions and growth capital. Even non-sponsored issuers have access to recapitalization dollars, albeit with slightly less aggressive leverage tolerances. Continued chatter respecting a recession could have a chilling effect on recap liquidity.
Story Receptivity
While the market continues to be exceedingly liquid for most issuers, “storied credits” and lower middle market (<$5MM EBITDA) issuers still face increased scrutiny due to a potential credit “down-cycle.“ Most investors will underwrite to a base case that bakes in a 10% to 20% reduction in EBITDA, especially for issuers in more cyclical sectors deemed most vulnerable to macroeconomic volatility. While the market is not closed to these issuers, they will be subject to higher pricing, less aggregate leverage (i.e. one turn less of EBITDA), and potentially some equity upside incentive features. Most bank lenders will consider all committed capital (whether drawn or undrawn) in calculating total funded debt. Continued chatter respecting a recession could have a chilling effect on liquidity for “storied” paper.