Is now the time to enter the credit markets?
Today’s M&A environment is white hot and competition for new deals is fierce. The availability of debt financing has fueled activity in the market, contributing to high valuations. Consider this: in 2017, fund managers raised a record $107 billion to invest in private debt, which includes direct lending, special situations, and venture debt, according to Preqin1. The amount of private equity available is also unprecedented with an estimated $1.8 trillion of dry powder according to McKinsey & Co.2 Partially as a result of these factors, asset valuations and debt multiples have soared, clearly changing return standards and underwriting expectations.
Debt in leveraged buyouts is creeping above the six times level that regulators said in 2013, following the financial crisis, was potentially too risky, for banks. The average company in an LBO had borrowings equal to 6.4 times earnings before interest, taxes, depreciation and amortization in the first half of 2018, according to Fitch Ratings3. Last year it was 6.2 times EBITDA and in 2016, it was 5.9 times.
Macro-economic conditions remain strong and competition from corporate acquirers with healthy balance sheets has been intense. Private equity firms are doing everything they can to win deals and they have turned to their debt providers for help. The U.S. leveraged loan market has grown to just over $1 trillion, according to Bloomberg4. However, since the financial crisis, traditional banks are no longer the main providers of debt. Commercial banks now account for less than 10 percent of the leverage loan market.
Following the financial crisis, the market has flourished with nontraditional debt sources supported by institutional investors who appreciate the principal preservation attributes of secured lending coupled with the premium return profile of the asset class. The asset class has attracted many new institutional investors as well as retail investors who have increasingly invested in Business Development Companies (BDCs).
However, despite the current appeal of debt, history shows that when market conditions turn, many less established lenders will recede into the trenches leaving private equity firms scrambling for solid financing partners once again. For example, the number of lenders that either went by the wayside or closed up shop during the financial crisis is almost too high to count—an estimated 465 banks filed for bankruptcy from 2008 to 2012 according to The Federal Deposit Insurance Corporation. In addition to the plethora of bank closings, a number of institutions either scaled back or sold off their portfolios. General Electric’s exit from the market represents the most prominent repercussion of the financial crisis.
With the long-term fundamentals of the asset class firmly rooted to be relevant in all cycles, Manulife Financial Corp. made the strategic decision to expand its Hancock Capital Management (“HCM”) platform to provide senior credit in the middle market. HCM has been investing alongside middle market private equity managers as a mezzanine lender and equity co-investor, for more than 20 years. The firm’s senior debt expansion plan now enables HCM to provide the entire spectrum of capital to its partners, including equity, mezzanine loans, and senior debt.
The expansion leverages the firm’s existing capital base, asset management resources, private equity client base and capital raising infrastructure. The move also brings Manulife Financial Corp. in line with many of its competitors such as Barings (MassMutual), who followed a similar path a few years ago.
Without a crystal ball to exactly time the market, a new product launch requires the right ingredients to manage through a late game entry point. The first ingredient is a “long-term approach to investing,” according to Steve Blewitt, head of HCM. “HCM represents a strong platform to build on, supported by Manulife’s global balance sheet and long heritage as a direct lender.”
A deep and broad base of resources is high on the list of fundamental ingredients. “We were fully aware of the market conditions when we chose to expand the capabilities of HCM. To be competitive in this environment you have to be relevant to those selecting their financing sources,” says Blewitt. “Adding senior debt products completes the full set of products and capabilities demanded by our clients.”
The right team is essential. The team charged with leading the senior debt effort is led by veterans of the industry: Devon Russell, Joe Romic, and Mike King who have worked at firms including Heller, GE, Antares, Bank of Montreal and Madison Capital Funding before joining forces at HCM. They are supported by 9 other investment professionals presently, and the firm plans to continue to hire to support its growth.
“They (HCM) had relationships in the business for a long time and they now have a senior presence. It’s a good experienced team. There’s a need for lenders to offer the broadest range of products possible. It keeps them from being selected out of a deal because they can’t speak to a particular product that a client wants,” says Anne Hayes, a partner with Riverside Company.
HCM’s strategy has resonated well within the private equity community. During the first nine months of 2018, HCM invested approximately $1 billion across many different asset classes, including first lien, second lien, equity co-investment and fund investments. The lender has worked with well-known middle market sponsors such as Parthenon Capital Partners, One Rock Capital Partners, Riverside Company, Audax Group, GTCR, MSouth Equity Partners and Kelso & Co., among others.
Growing HCM’s product set substantially has made it a “go-to” lending source for private equity firms. The firm is able to provide revolvers, traditional term loans, unitranche financings, 2nd liens, traditional mezzanine debt, structured equity, and equity co-investments. Russell noted that “having the full suite of products provides our private equity clients tremendous optionality when they are considering the capital needs of a given investment.” This value proposition creates more “at-bats” with each sponsor which deepens the relationship while affording HCM a more disciplined approach to capital deployment.
Case and point. In early 2018, MSouth Equity Partners was looking to recapitalize their portfolio company USA TV, which is a local TV broadcaster that owns ABC, NBC and Fox affiliates in Tier 2 markets such as Tupelo, Mississippi, Eugene, Oregon and Encino, California. MSouth had owned the company for three years. The deal was complicated given the industry, the use of proceeds and existing lender group dynamics. It was important to both MSouth and the USA TV management to maintain a relationship with the incumbent senior lenders, which included commercial banks, while optimizing their capital structure which does not always line up well in the intensely regulated commercial bank market.
“The existing senior lenders were supportive of a dividend recap at the leverage profile we were targeting, but they were not interested in funding the transaction with all senior debt.” says Anthony Hauser, a partner with MSouth Equity Partners. While HCM offered to provide a traditional unitranche financing solution among other options, MSouth collaborated with HCM to structure a synthetic unitranche facility that enabled the firm to maintain its relationship with the incumbent senior lender, reach its leverage and dividend targets, and eliminate the need for more expensive mezzanine debt financing. “We accomplished this by reengineering the terms of our existing credit agreement to create a first-out tranche for the incumbent senior lender and a last-out tranche for HCM. While complex and unique to MSouth, the documentation and execution process was extremely efficient,” says Hauser. “HCM has demonstrated a unique ability to quickly understand critical capital structure issues, provide creative financing solutions, and operate under compressed transaction timetables.”
HCM generally avoids the broadly syndicated market and specializes in the middle market, typically working with companies with as little as $5 million of EBITDA and larger. Nonetheless, HCM has completed deals with companies that have more than $100 million of EBITDA to maximize the firm’s addressable market at a time when selectivity is critical to long term success. Russell notes, “building a new loan portfolio at such a late stage in the cycle requires discipline and patience. Discipline comes from an appropriate source of patient capital, and a relevant product set to generate a large funnel of new financing opportunities which in turn creates selectivity.”
While a broad mandate is a luxury to attract a lot of financing opportunities, consistency and predictability along with good communication are key to maintaining that funnel. “Our private equity relationships know what we like and what we don’t. In an environment when everyone is pushed to win a deal, there are some fundamentals in the middle market that must be maintained in all cycles—targeting proven businesses tested through a cycle, thorough diligence, and good documentation that includes standard protections such as financial covenants,” says Russell. “Everyone loves a home-run, but we are happy with a lot of singles and doubles in this environment. It’s a long game.”
1 www.barrons.com/articles/wall-street-rushes-into… July 20, 2018.
2 www.feg.com/insights/fourth-quarter-2017-private-capital-quarterly. February 27, 2018
3 peureport.blogspot.com/2018/05
4 www.bloomberg.com/news/articles/2018-05-18/