Spring 2014
The winter months were unusually cool in late 2013 and early 2014, and most middle market borrowers and lenders will likely concede that lending activity during those months was equally cool. The optimism for robust deal flow in 2013 never materialized into actual results, even though most middle market lenders remained quite optimistic until the bitter end. Spring, however, is a time for rejuvenation. Most prognosticators seem to agree that the relevant economic factors that usually indicate increased deal activity seem to be alive and well in early 2014. For example, the cost of credit still remains historically low, and while most agree that interest rates have nowhere to go but up, these historically low rates will more than likely be available to middle market borrowers throughout the remainder of 2014… if they can find the right middle market lender to make the loan. Senior lenders have continued to aggressively court borrowers with good credit and strong collateral, and these borrowers have been fortunate enough to obtain senior loans at historically low pricing. In fact, the competition for these strong borrowers has caused some senior lenders to revert back to pre-2008 levels not only with respect to pricing, but also with respect to higher leverage ratios and relaxed covenant packages. Unfortunately, for a number of middle market companies, particularly those who are not deemed to have "good credit and strong collateral", obtaining credit from senior lenders has continued to be challenging.
One of the positive notes to come out of 2013 was the noticeable uptick in activity within the mezzanine lending market. In fact, middle market borrowers are suddenly presented with a meaningful amount of junior capital flowing to the middle market, a trend that has been triggered by a rise in mezzanine fundraising levels, as well as a significant amount of SBA leverage available to the middle market as a whole. Mezzanine lenders have continued to increase staffing and capital-raising activities for some time now, and more importantly, they have instituted capital deployment strategies in addition to traditional mezzanine lending, such as equipment lending and other such specialty finance opportunities. To date, mezzanine lenders have focused their lending activity towards the higher end of the middle market; however, we are hopeful that mezzanine capital will soon be deployed in the heart of the middle market over the course of 2014.
M&A activity is usually a good indicator of increased middle market loan activity; however, M&A activity was slow throughout 2013 (for a second straight year). On the other hand, private equity players accumulated significant amounts of capital throughout 2013, and this fact, coupled with the overall stabilization of middle market companies, makes us hopeful that private equity will be an important driver for increased lending activity in 2014. Private equity firms have taken advantage of investment opportunities requiring disproportionately high amounts of equity, and over the past two years private equity has once again established itself as a viable option for middle market companies requiring capital in excess of that which is available in the senior and mezzanine debt markets.
Based on an informal survey of senior lenders, mezzanine lenders and private equity firms, the following is a summary of deal terms in today's market for financially strong middle market privately held businesses:
Senior Debt
Leverage Ratio:
- Loan amounts for well capitalized companies are in the range of 2.5 to 3.0 times trailing 12-months EBITDA for companies with less than $15 million EBITDA, but there are noticeable upward exceptions in the 3.0 to 3.5 times trailing 12-months EBITDA range (the trend has continued its upward trajectory throughout 2012 and into 2013).
- Loan amounts are int he 3.0 to 4.0 times trailing 12-months EBITDA range for companies with more than $15 million EBITDA (consistent with 2012).
Interest Rates:
- 30-day LIBOR plus 1.75% to 2.50%, or Prime Rate plus 0.25% to 1.00%, for revolving debt with full collateral coverage (with more senior lenders competing for good quality borrowers and in some cases offering interest rates far less than those listed above);
- 30-dat LIBOR plus 1.75% to 2.50%, or Prime Rate plus 0.25% to 1.00% for 3-5 year term debt (with more senior lenders competing for good quality borrowers and in some cases offering interest rates far less than those listed above);
Advance Rate:
- 80% to 85% of Accounts Receivable (with senior lenders more willing to provide higher advance rates to borrowers with less than 5% A/R dilution);
- 50% to 70% of Inventory (depending on the nature of the Inventory), based on either a forced liquidation valuation or net orderly liquidation valuation (net orderly liquidation valuation is significantly higher than forced liquidation value and has now returned as the more typical benchmark). The advance rate on Inventory is often lower for smaller companies, in part because senior lenders choose not to incur the expense of a third party Inventory appraisal.
Fees:
- 0.00% to 1.0% of loan amount (senior lenders are beginning to waive all fees; however, they continue to charge fees or expect other forms of reimbursement for loans secured by fixed assets or real property due to appraisal costs and other expenses incurred by senior lenders);
- Unused line fee of 0.125% to .50% for revolving debt with a term greater than 364 days (consistent with past practices), although many senior lenders are using 0.25% as their benchmark.
- Bank service fees and covenant waiver fees are still applicable; however the cost of such fees has decreased over the past two years, depending on the nature of the bank service and/or covenant waiver.
Mezzanine DebtPre-September 2008, it was common place for senior lenders to provide financing in excess of collateral value (otherwise known as "cash flow loans"). In 2009, cash flow loans became the exception and were usually supported by personal guaranties from one or more stakeholders with substantial net worth. Throughout 2010 and 2011, cash flow loans began to reappear for borrowers with very good credit, although interest rates for such cash flow loans were typically at the higher end of the LIBOR rates stated above. Since then, senior lenders have become more aggressive with cash flow loans, at least with respect to companies with more than $10 million EBITDA. The principal amounts of such cash flow loans are typically not more than 1.0 to 2.0 times trailing 12-months EBITDA, with no more than 3-5 year terms. We anticipate this upward trend will continue, albeit only for borrowers with very good credit.
Leverage Ratio:
- Loan amount, including senior debt, not to exceed 4.0 to 5.0 times trailing 12-months EBITDA (consistent throughout 2013), depending on the quality of the borrower and the amount of senior debt.
Interest Rate:
- 12% to 14% with 10% to 12% current pay and 1% to 3% paid in kind, for companies with less than $15 million EBITDA (noticeable decrease since 2012); and
- 11% to 13% with 11% to 12% current pay and 1% to 2% paid in kind, for companies with more than $15 million EBITDA (noticeable decrease since 2012)
Fees:
- 1.0% to 3.0% of loan amount (consistent with 2013).
Warrants:
- Warrant coverage to provide mezzanine lender with an all-in IRR of 12% to 18% (consistent with 2013), although with increased mezzanine competition, the inclusion of warrants has reduced over time.
Equity Financing
IRR:
- 20% to 30% IRR (consistent with past practices).
Valuation:
- 4.5 to 9.0 time trailing 12-months EBITDA, with signification variation based on company size, industry and growth trajectory.
Debt to Equity Ratio:
- 35-40% equity/60-65% debt (up from historic lows of 20% equity/80% debt pre-2008, but down from 50% or more of equity in 2008/2009).