Q & A

What's Old Is New: Middle Market Buyout Financing

Jim McCormick is a Managing Director with Boenning & Scattergood, Inc. Boenning & Scattergood, Inc. is a middle market investment banking, securities, and investment management firm that been in business for nearly a century. Jim has worked extensively with both public and private business owners on numerous M&A and corporate finance transactions across a wide range of industries.

M.A.: How has what has happened in the market altered the financing of deals?

J.M: In today's tight credit markets, buyers and sellers of companies often must find creative ways to secure the capital necessary to close a deal. As a result, financing alternatives such as seller notes, earn outs, mezzanine debt with equity warrants, and seller equity roll-over requirements, which were less common during recent years when the deal market was at its peak, are returning

During the M&A boom of 2005 through 2007, and prior to the collapse of the credit markets in 2008, middle market buyouts could be financed with equity investments of 40% or less. Accordingly, even smaller middle market deals used comparatively high levels of leverage with total debt to EBITDA (cash flow) ratios reaching 4.0x or higher. Ample debt combined with low interest rate spreads enabled leveraged buyout groups to pay higher prices and still (or so they thought) achieve their target rates of return.

In today's deal environment, however, senior cash flow lending is on the endangered species list and asset based lending is back in vogue. Finding senior debt for deals involving companies with few "leveragable" assets can be quite challenging. Also, banks and other senior debt lenders have reduced considerably the amount of leverage they will provide to finance a transaction.

Where once senior debt-to-EBITDA levels in middle market buyouts may have reached 3.5x EBITDA or higher, now senior debt to EBITDA levels may only reach 1.5x to 2.5x EBITDA. Also, loan pricing spreads are wider and loan covenants more restrictive.

M.A.: In your opinion, is mezzanine financing a viable and available source; and if so what is its role?

J.M.: To some degree, mezzanine lenders have helped fill the gap left by senior lenders, particularly in deals where the company has limited assets available as loan collateral.

Given its risk profile, mezzanine debt carries a high fixed current interest rate and may also feature equity warrants, which are essentially nominally priced equity options that increase the mezzanine lender's all in return upon exercise.

A few years ago, the abundance of senior and second lien debt in the market forced many mezzanine lenders to lower their interest rates and target rates of return rather than sit on the sidelines.

In today's environment, however, middle market mezzanine lenders are able to get fixed current annual interest rates of 12% or more, an additional 4% in payment-in-kind interest that accrues to principal, and equity warrants that generate potential all in target rates of returns near 20%.

Consequently, the spread between mezzanine lender target rates of returns and equity sponsor target rates of returns, which may be as low as 25%, has narrowed considerably.

M.A.: In this environment, what kinds of costs are buyers encountering?

J.M.: In today's tight credit markets, some buyers may seek to use earn outs as a way to reduce the amount of cash required at closing. While earn outs can appear simple in concept, they are cumbersome to document and even more difficult to track and measure going forward after ownership control has changed.

As a result of the scarcity and/or relatively high cost of debt capital, buyers are now required to contribute more equity to fund acquisitions and it is not uncommon in today's financing environment for equity to represent 50% or more of the capital structure at closing. Consequently, buyout groups are more disciplined in terms of valuation multiples and are increasingly seeking financing assistance from sellers.

M.A.: In your experience, what is being asked of sellers?

J.M.: Two common ways in which sellers are asked to help finance buyouts are through the acceptance of some portion of the purchase price in the form of an interest bearing note or by "rolling over" a significant portion of the equity value they receive in the transaction back into the deal at the new leveraged equity price.

While private equity groups have always preferred owners staying with the business to keep some "skin in the game," the amount of "skin" required has gone up. As a result, sellers may be required to contribute what equates to 20% or more of the equity at closing in the form of a seller note, roll over equity, or some combination of the two.

M.A.: Are we witnessing historic changes or is something else going on?

J.M.: Whether it is valuation multiples or leverage multiples, in many ways, middle market M&A transaction metrics have reverted back to their historical means. Similarly, senior debt lending has reverted back to the concept of a "second way out" referring to a company's underlying assets and not its enterprise value.

The good news is that, unlike the mega million and billion dollar deals of a few short years ago, middle market M&A deals are still getting done and transaction financing is still available, albeit at more conservative leverage levels and at higher pricing spreads, though base rates are relatively low. Additionally, good companies with strong management teams and defensible, sustainable market positions will always be in demand and command attractive valuations.

M.A.: Thank you.