Source Talks ep. 30
In this interview, David Toll of PrivateEquityCareer.com speaks with David Acharya, Managing Director at Acharya Capital Partners on their multi-pronged approach to find opportunities, and the value of using data to score your origination strategy relative to competitors.
Credit markets hold firm, even as banks sound alarms: 5 Questions with Brad Stewart of Capital Solutions
So much money has poured into the direct lending market over the last few years that it remains very much open for business despite high inflation and economic headwinds. At the same time, credit analysts within banks are starting to push back on the high leverage multiples of recent years.
That’s according to R. Bradley Stewart, partner at Boston-based The Capital Solutions Group, which provides both debt advisory and restructuring advisory services to deal sponsors and other clients.
Capital Solutions tends to get called into in two types of situations, said Stewart. In one, the sponsor simply lacks the expertise and resources to secure the best financing deal on their own. In the other, the sponsor seeks loans on behalf of a company that has flaws—high customer concentration is a common one—that make it a tough sell for most lenders.
A typical assignment for the four-person firm is to raise $30 million to $50 million to help finance a North American lower-middle-market buyout or recapitalization.
Below we ask Stewart five questions that help provide a snapshot of the financing market for lower middle market deals:
How would you characterize the M&A market for buyout firms and independent sponsor deals? We’re in an interesting place. Last year potential sellers were concerned that the capital gains rate was going to go up. So if they had built a nice business that came through the pandemic well they pushed to get that deal done. That helped make 2021 a gangbuster year. But deals began drying up in the spring as rising inflation dominated headlines. Buyers and sellers both paused to figure out whether companies were going to be able to pass their higher costs on to customers. While we now have those answers, we’re facing the prospect of a recession thanks in part to the government’s effort to curb inflation. Overall, I would say sponsors are having trouble finding high-quality deal flow right now. It feels a tad bit below what I could call a normal market.
How are the lenders reacting to market conditions? People in the financing markets are assuming that the economy is going to slow down. The big question is whether the economy is heading for a soft landing or for a hard crash. But whatever their prediction, lenders across the board believe that the probability of a recession is much greater now than it was a year ago. And so they’re thinking is, Maybe we should hold the line on leverage multiples.
How is the prospect of a recession factoring into sponsor decisions about credit? With both unitranche loans and asset-based loans, covenants and amortization schedules are moving up in importance for sponsors. If we do enter a recession, liquidity becomes that much more important to companies. They will want as large a performance cushion as possible before tripping covenants. They also want to back-end repayment schedules to save cash. On both fronts heavily regulated banks can be at a disadvantage to private credit funds. Inside banks you have a constant tug between the deal originators and the credit analysts. When the M&A market is full speed ahead, the originators sort of rule the roost and tell the credit guys, We gotta get this deal done. But when the economy turns, the credit guys wield a lot more power and are able to push back and get the originators to pull in the reins. And that’s where we are now. Through conversations I’m hearing that the credit guys are starting to push back.
Last spring when we spoke you were seeing six-times leverage multiples on garden-variety deals and L+400 to L+500. Where are we now? Leverage has pulled in a little bit, but not as much as you’d think given all the new credit funds coming online since we last spoke. A recession-resistant grocery business with a very credible story might still command a six-times leverage multiple. But in terms of averages and medians, leverage multiples have pulled back to 5 and a half to five and a quarter. And if you have a dubious recession resistance story you’re going to be below that. Lenders are getting better yields, thanks to increases in the LIBOR and SOFR benchmark rates, even as spreads have remained relatively stable. I would add that banks have been trying to push the spreads up a bit, since they themselves rely so heavily on short-term borrowing for their capital.
What kind of financing is most popular with sponsors? Unitranche financing is still very much the flavor of the day. It’s to the point where SBIC funds and other traditional sources of mezzanine financing have completely capitulated; they’ve largely switched to offering unitranche loans. Asset-based lending is also gaining in popularity as a relatively inexpensive form of financing…
Cautious Optimism: Signals of Investor Demand for 2H 2022
Recent years’ events have given us in the M&A deal sourcing world a sort of whiplash not previously encountered. The steady growth of deal activity over the past decade has been suspended, with the initial pandemic drop giving way to soaring levels through 2021. That boom has been punctuated by looming threats of a decline induced by today’s turbulent economy, supply chain shock, rising inflation and interest rates, and geopolitical tensions – to name a few contributing factors.
Sponsors Grow More Desirable as Deal Sources
Owners of family-run companies typically avoid selling during economic downturns. Far better, they figure, to wait until cash flows and valuations revive. Similarly, corporations prefer hanging on to non-core divisions until better times arrive. That way the cash generated from the sale for shareholders can be maximized. Sponsors that have companies ripe for sale like strong economies and high valuations as much as the next seller. But they also have motivations to sell that other kinds of sellers don’t, even during downturns.