Prior to Covid-19, the private equity industry had been on a tear. In fact, global private equity deal value in 2019 reached $551 billion, according to Dealogic. Healthy credit markets fueled private equity deal activity in recent years. Last year, more than 75 percent of the total deals closed had debt multiples of higher than 6x Ebitda, according to Refinitiv. More than 55 percent of U.S. buyout deals in 2019 had a purchase price multiple of above 11x, according to Refinitiv.
Then came the global pandemic, and everything changed. Middle-market lending activity came to a screeching halt in the second quarter. Leveraged lending levels fell by 80 percent from January through April 2020, according to Dealogic. Deal volume also took a hit.
Today, the private equity market is making its way back to a new norm. One of the key factors pushing the PE-backed transactions forward is support from lenders, who are ready, willing and able to lend.
“Privately-owned companies continue to raise capital in the debt market, despite the disruption caused by Covid-19, the recession, and the falloff in the energy market,” says Kent Brown, a managing director and head of Capstone Headwaters’ debt advisory group. “Every day that goes by, the market seems to be normalizing. It has not recovered for sure, but the trends are going in the right direction. We don’t think the market will get back to where it was in January anytime soon, but the tone feels better, and deals are getting done.”
Private credit vehicles raised $57 billion in the first half of the year, according to Preqin. Contributing to the dry powder available for deals, in August, Monroe closed its latest collateral loan obligation fund, Monroe Capital MML CLO X, with $406.3 million.
“There is plenty of capital on the sidelines, and it’s really the private credit asset managers who are driving this market and financing the acquisitions,” says Ted Koenig, president and CEO of Monroe. “If there is a certainty of cash flow for a business and the deal can be underwritten based on projected cash flow, it will get done.”
Bank lending seems to be another story. Many observers believe banks are distracted with administering the Paycheck Protection Program and the Main Street Lending Program. “Many banks have bandwidth issues, given the requisite administration and reporting requirements of these loan programs,” says Gretchen Perkins, a partner with Huron Capital.
That said, the deals that are getting done are getting done at higher prices than pre-Covid-19 levels. Market feedback indicates leverage for new loans is 0.5- 1.5 turns below pre-Covid-19 levels, according to Capstone Headwaters. It’s important to note that leverage levels are highly dependent on industry sector and company performance throughout the crisis.
ADD-ONS ARE HOT
At the start of Covid-19, add-on acquisitions became the darlings of the private equity world. In fact, add-on acquisitions made up the highest percentage of buyouts on record, according to Pitchbook Data.
Add-ons have seen strong support from the lenders. “There is a fair amount of activity with private equity firms doing add-on acquisitions opportunistically,” says Jeri Harman, founder and chairman of Avante Capital Partners. “They are adding on products, services, customers or geographies that are extensions of what they have. Add-ons are more attractive today. It is easier to buy them at reasonable valuations.”
Add-ons also tend to leverage the expertise both the investor and the lender have developed in a sector through backing the platform company. At a time when site visits and unfettered access to a target company are not possible, anything that adds confidence and knowledge to a deal is a big advantage.
Huron’s recent investments drive the point home. The Detroit firm has completed more than 10 add-on acquisitions since the beginning of Covid-19 and has seven more add-on acquisitions under letter of intent. The firm completed add-ons in the insurance brokerage industry, energy efficiency, fire and safety and HVAC industry to name a few.
Although add-ons have taken the lion’s share of deal volume, demand for financing new platform deals is starting to come back, at least anecdotally. Sector does play a critical role.
“We are definitely starting to see more demand on the new deal side, but it’s industry specific,” says Koenig. “In the last 45 days we have seen platform acquisitions getting done again as opposed to just add-ons and tuck-in deals. It shows the deal market is starting to make a comeback in areas that aren’t affected by Covid-19 We hadn’t seen platform acquisitions getting done prior to that.”
Sectors that are seeing deal volume pick up in the pandemic include: business services, logistics, trucking, warehousing, software technology, cloud services.
One recent example: Capstone Headwaters recently closed a senior secured credit facility for Align Capital Partners’ purchase of Electronic Transaction Consultants Corp., a tech-enabled business services provider.
“While most lenders say they are open for business, many are really just wanting to see what’s out in the market and are not actively underwriting and funding new deals,” says Capstone’s Brown. “They are uber-cautious and selective. For many of them, if they can’t find a transaction in an easy industry, offering low leverage, high pricing and lots of equity support, they may not do the deal. The businesses that have been attracting money from lenders are those that have proven they are largely Covid-19-protected.”
Sectors with little to no activity include: hotels, auto, airlines, entertainment and some consumer sectors, telecommunications and oil & gas. In fact, some of these sectors are already experiencing issues with their loans. Telecommunication comprises about 20 percent of leveraged loan defaults, followed by oil & gas (about 13 percent) and retail (about 12 percent), according to Capstone Headwaters.
Conversely, Huron’s Perkins says new platform companies that are not negatively impacted by Covid-19 are seeing strong purchase price multiples, given the Covid-19 resistance premium they are ascribed and the scarcity premium as well, since the number of deals in the market is significantly below last year’s levels.
“These are companies that have proved their sustainability in difficult times,” says Perkins. “Companies that have demonstrated Covid-19 resistance will certainly have debt available to them to transact, but likely at one turn lower than pre Covid-19 levels.”
Avante’s Harman agrees. “Lenders Jeri Harman “Now we are busy again. It’s not like last year, but there is good deal flow.” Lenders are going to be careful in terms of how aggressive they will be. They are looking for deals that are less impacted by Covid-19, because things can obviously still get worse. New platform acquisitions will continue to get done, but in the right sectors. While pricing has increased, there is pressure on pricing for the right deals as well.”
Avante has closed three new deals during the second quarter, including two in the healthcare space. One was a physical therapy company. The other was a medical device manufacturer that makes highly engineered devices used in respiratory applications. Those became critical during the height of Covid-19.
“When Covid-19 hit, everything stopped,” says Harman. “We were looking internally to understand where our portfolio was and figure out how we could help existing portfolio companies. That lasted until May. Now we are busy again. It’s not like last year, but there is good deal flow.”
Of course, prior to even looking at new deals, private equity firms and lenders alike looked internally at how their portfolio was doing and where they may need to provide some extra support. For owners, sustainability became all about liquidity. “When you own a company, it’s not about Ebitda or exit value, it’s about liquidity,” says Koenig. “We took a look at the more than 500 companies we have in our portfolio that we have lent money to. For the ones that are impacted by Covid-19, the question is, do they have enough liquidity? There are only a few sources where liquidity can come from.”
Liquidity can come from three likely sources: PPP loans, lenders, or the private equity firms themselves. Many PE firms turned to their lenders first.
“Assuming the PE firms are cooperating and acting responsibly, in cases where it makes sense, lenders are making adjustments, resetting covenants, changing amortization periods and modifying existing loan agreements to make sure portfolio companies are liquid,” says Koenig. “It’s a partnership.”
Refinancings are also more popular. With low interest rates, companies can reduce their overall average borrowing costs and strengthen their balance sheets. Brown reports that Capstone has worked on two refinancings recently. He says pricing levels have stabilized, if not declined a bit, since the April/May timeframe, as the expected rush of high-rate opportunistic deals did not materialize, and lenders have sought ways to deploy their available capital in the market.
“We have also been involved in a couple of loan-amendment situations recently,” Brown explains. “In those situations, we have seen private equity firms be pretty supportive of their portfolio companies and willing to put more equity dollars in to augment liquidity levels and see their businesses through this rough patch. Lenders and sponsors both recognize that maintaining sufficient liquidity is hyper-critical to these businesses at this time.”
Private equity firms hope it stays this way. “Lenders have been generally cooperative,” Perkins says. “The big question is when will lenders start demanding modifications, like repricing or debt paydown, as result of Covid-19-related underperformance,” says Perkins.
What comes next?
“When the PPP loans run out, there likely won’t be significantly more stimulus, and if another wave of Covid-19 hits, we could see more job losses,” Harman says. “I don’t see this as a V-shaped recovery. We will be in a recession. The question remains, how deep and long will it be?”
More loans are expected to default in the coming months. The default rate of U.S. leveraged loans increased to 3.7 percent at the end of June, up from 2.0 percent in March, according to Capstone. That’s the highest it’s been since September 2010. For historical perspective, it’s worth remembering that 8.5 percent was the norm during the Great Recession. As the pandemic persists and stimulus efforts abate, fund managers expect default rates to tick higher and reach 5.3 percent by the end of the year, Capstone predicts.
Lenders expect to be busy but selective throughout the rest of the year. “Lenders are still picking up the phone and actively considering new transactions,” Capstone’s Brown says. “Every day that goes by, we see signs of the market getting back to more normalized activity levels.”