Going into March, unlike the traded 144A and public capital markets, the private market is still open for business with minor immediate impact on pricing and leverage due to novel Coronavirus concerns or the collapse of oil prices. The only exception would be lower middle market companies (<$7.5MM LTM EBITDA), “storied” credits, and issuers in sectors likely to be most adversely impacted by the CDC “social distancing” guidelines (i.e.–hospitality, travel, event, and trade show related industries). Though that is the “official line” for most investors, the larger reality is that most lenders are taking a “wait and see” approach to see how the current crisis plays out. While they will look at deals, we fully anticipate that the deal cycle will elongate with greater time spent on diligence and documentation to get a better sense of how sensitive an issuer is the new environment. Though the same underlying excess liquidity conditions that characterized January and February remain static, especially in the non-bank direct lending space, all transactions are going to be scrutinized much more carefully.
Until the private investment community gets further guidance respecting the severity and duration of the current crisis, most lenders are still acting as though they are actively seeking to put money to work. There is also a possibility that the current meltdown of the 144A high yield market may bleed into the private market, especially for lenders that participate in both markets and focus on relative value. Lenders whose stock is traded publicly (BDCs for example) may also have their own liquidity constraints due to declining share prices, or “marks” (write-downs) to poor performing assets which will impact their investment strategy.
Suffice to say however that the underlying macroeconomic conditions existing in the immediate “crisis” are fundamentally different from those that existed prior to the great recession, and that any dislocation in the private market is likely to be more of a timing issue than a shutdown of credit. By the same token, any secular event that materially impairs credit quality, even for the short term, will potentially influence transaction behavior, pricing, leverage metrics, covenant structures, EBITDA adjustments, and even the timeframe of deal closings. The below capital markets summary from SPP Capital Partners can be viewed in full here: http://sppcapital.com
Minimum Equity Contribution
Notwithstanding the more aggressive quantitative pricing and leverage metrics, from a qualitative perspective, most lenders remain quite wary of thinly capitalized deals. A minimum aggregate of 40% base level equity (inclusive of any rollover) is still required for most deals, with at least 20%-25% minimum new cash equity being the norm. As leverage levels creep up in excess of 5x EBITDA, 40%-50% cash equity (exclusive of rollover) is required.
Equity Investment and Co-Investment
There is no dearth of liquidity for both equity investment and co-investment in the new year, as well as robust support for independent sponsors (especially in the case where an independent has secured an LOI at sub-auction level pricing). Capital for direct equity investment (and co-investment) is plentiful among insurance companies, family offices, and select BDCs and SBICs. Unitranche providers increasingly request equity co-investment to complement their debt investment, though usually this is not a condition required for the debt component. The number of credit opportunity funds capable of providing both debt and equity tranches has increased over the course of 2019 as well. 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 liquidity preference (i.e. - preferred vs. common shares).
Recap Liquidity
Though it is too early to assess the impact of the Coronavirus on recap liquidity, we do know that going into the month, conditions for dividend and share recapitalizations were on solid footing, particularly for sponsored transactions. In most cases, pricing and terms for “non-accretive” recapitalizations mirrored those of more “accretive” uses of capital such as acquisitions and growth capital. There is no doubt however that a recap combined with an acquisition will be more positively received, especially in the current environment. Though less bountiful, non-sponsored issuers also have access to recapitalization dollars, albeit with slightly less aggressive leverage tolerances. If in fact macroeconomic conditions do materially deteriorate as a result of the current crisis, recap liquidity will certainly be negatively impacted (it literally shut down in 2008).
Story Receptivity
Generally, the first quarter of the year is the most advantageous time of the year for “storied” or more credit- challenged transactions. That yearly narrative may in large part have ended with the onset of the current crisis as lenders are going to hold back on riskier credits until they get a sense of where things stand in the market, and more specifically, if the current fears morph into a more pronounced economic downturn. Timing will be key as investors will likely wish to “slow-track” deals until they see how a given issuer will perform given the perceived operating obstacles.