All relevant disclosures and certifications appear on pages 4 - 5 of this report.
September 18, 2009
Things Starting To Look Up, State of the MiddleMarket Dinner Recap
Greg Mason, CFA (314) 342-2194masong@stifel.comTroy Ward (314) 342-2714wardt@stifel.comJonathan Bock, CFA (314) 342-2918bockj@stifel.com
We recently hosted our second "State of the Middle Market Dinner" which featured three middle market participants;David Golub (Golub Capital - private debt), Chuck Brizius (Thomas H. Lee Partners - private equity) and Michael Arougheti (Ares Capital – public provider of private debt). The dinner was held in Boston and was a successfulfollow-up to our New York event held in early June.One of the not so subtle differences at this event was the overall "tone" regarding the current environment. Below arethe key takeaways from the dinner:• Economic Performance: EBITDA levels have stabilized but limited revenue drivers will prevent a quick EBITDArebound.• Middle market pricing remains attractive. A significant credit market rebound in liquid investments (large syndicatedloans & high yield bonds) has not caused irrational pricing in the illiquid middle market.• The favorable lending environment is likely to continue as banks and irrational competitors will not likely to return tothe markets for a significant period of time.• The pipeline for new (primary) investment opportunities is building rapidly and 4Q09 should see significantly higher M&A volumes.• A massive $800 billion in debt ($300 billion in debt refi and $500 billion to fund new private equity deals) is neededin the next two years. This is expected to be met by new capital and "amend & extend". This should extend theattractive lending environment.• Final Tidbit: The panel was unanimous in the view that the public equity markets have likely overshot thefundamental economic trends and the credit markets are lagging the equity euphoria.
Economic Performance: EBITDA Levels Have Stabilized but Limited Revenue Drivers Will Prevent a QuickEBITDA Rebound.
One of the advantages of having three middle market participants is their insight into the currentstate of operations at their portfolio companies. Overall the assessment was that EBITDA has stabilized for the mostpart and several sectors are showing slight improvement in EBITDA. One area that was pointed out as still under pressure was luxury goods which were described as "still struggling". Outside of industry exposure the best protectionagainst EBITDA compression was aggressive management at the portfolio company level. Managers who recognizedthe severity and implemented cut costs early have protected substantial value. While EBITDA levels are stable, allthree speakers see limited revenue growth which is the needed catalyst to begin driving EBITDA levels higher. As aresult, they expect a "muddling our way along" with flat to slowly rising EBITDA levels for the foreseeable future.
Middle Market Pricing Remains Attractive. Significant Credit Market Rebound in Liquid Investments (LargeSyndicated Loans & High Yield Bonds) Has Not Caused Irrational Pricing in the Illiquid Middle Market.
Similar to our NYC event, the participants provided prevailing middle market pricing levels for senior debt, mezzanine debt(aka subordinated debt) and "uni-tranche" opportunities. First, leverage levels have declined meaningfully due to acombination of lower overall purchase multiples and larger equity contributions. See
Figure 1.
Last out debt is nowonly 3.5x EBITDA versus 5.5X at the peak of the market. In addition, the lower multiples today are based onrecession-level EBITDA whereas the higher multiples at the peak of the market were also based on peak EBITDAlevels. As a result, on an actual dollar basis leverage and purchase values have fallen dramatically. Second, totalreturns are very attractive in the middle market with IRR's of 9-11% for senior debt and 18-20% for mezzanine debt.See
Figure 2.
Given the scarcity of capital in the market, the participants that do have capital are finding theuni-tranche product (combination of senior and sub debt) very attractive. This product allows the provider to be theonly debt in the transaction and offering an attractive blended rate while retaining the senior position.
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Figure 1 - Purchase & Leverage Multiples (2006/2007 vs Current)
Purchase & Leverage Multiples (2006/2007 vs Current)EquityTotal as a % of Purchase Senior Mezzanine TotalPrice Debt Debt Equity Purchase2006/2007Vintage
8-10x 4x 4-5.5x 2.5-4.5x 33%
Current
6-7x 2-2.5x 3.5x 3.5x 50%Source: State of the Middle Market discussion
Multiples of EBITDA
Note: 2006/2007 multiples were on peak EBITDA levels while current multiples are onrecession EBITDA levels. Thus on a dollar basisleverage and purchase prices have fallen significantly.
Figure 2 - Current Market Pricing For New Middle Market Loans (Primary Issuance)
Current Market Pricing For New Middle Market Loans (Primary Issuance)TotalCash PIK Interest Upfront Prepayment TotalInterest Interest Rate Fees Penalties IRRSenior Debt
L+ 6-8%w/ LIBORfloor of 2%None 8-10% 2%Not mentioned as a key returncomponent
9-11%Mezzanine Debt
11-13% 2-3% 13-16% 2-3%Pre-payment penalties of 3-5% stepping down to zeroover life of the loan
18-20%
Source: State of the Middle Market discussion
Attractive Lending Market Likely To Continue As Banks and Irrational Competitors Not Likely To Return for aSignificant Period of Time.
When asked about competition in the middle market our speakers discussed the massivefallout of investors previously in the market place. Many of the large commercial banks are out of the market includingLa Salle, Wachovia and Bank of America. Only Wells Fargo is left lending to the middle market through its WellsFoothill subsidiary. All of the CLOs and debt vehicles financed with CLO debt are gone (Cratos, GSC Group and manymore). Hedge funds that were buying the bank loan market and leveraging the balance sheet with repo debt arecompletely gone. Several large BDCs (ACAS & ALD) are out of the market. Management said the list of remainingcompetitors is much easier to list. There are a few healthy regional banks (US Bank mentioned), a few healthy BDCs,Golub Capital, GE Capital is lending again, and TCW and Oaktree are active in the upper-end of the middle market. Allspeakers agreed that the remaining competitors are all rational investors and there are enough opportunities for everyone without the need to become aggressive on pricing. Finally, expectations were that the attractive lendingenvironment will remain for a while as irrational competitors (hedge funds & CLOs) will not receive funding for a longtime and increased regulations on banks will prohibit them from becoming aggressive in the middle market space.One additional interesting tidbit is that the upper-end of the middle market is currently less competitive than thelower-end while historically, the opposite is true. As one speaker explained, "it's much easier to find someone todaythat can make a $20 million investment to fund a smaller investment than to find someone who can make a $100million investment in a larger investment.
The pipeline For New (Primary) Investment Opportunities Is Building Rapidly And 4Q09 Should SeeSignificantly Higher M&A Volumes.
M&A activity is building with buyer and seller expectation convergence as wellas rational debt pricing being made available (rational for both lenders and equity investors). Earlier this year when thesecondary markets were yielding 20-30%, private equity investors could not effectively utilize debt for new investmentswith those types of yields; however, our PE speaker, Charles Brizius of TH Lee, stated that current yields mentionedabove for senior and mezz debt are very workable in new investment structures. To quote Mr. Brizius, "this is anenvironment where both the lender and equity sponsor can win". This is a noticeable difference from the NYC dinner where M&A activity still had many road blocks and our speakers believe that 4Q09 will see "significantly higher M&A
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volumes".
A Massive $800 Billion In Debt Is Needed In The Next Two Years Met By New Capital And "Amend & Extend".This Should Extend The Attractive Lending Environment.
There is a $300 billion wall of debt coming due in thenext two years that will need to be addressed. In addition there is another $500 billion of private equity capital thatneeds to be invested or it must be returned to the LP's (which isn't going to happen). Based on current structureswhere equity invests 50% and debt is 50% this implies that an additional $500 billion of debt is needed to fund theprivate equity investments. First, our panel believes that the $300 billion of debt coming due will be handled outside of the courts through amending and extending the loans. While this could lead to some difficulty for debt investors thatneed repayments (this is becoming less an issue as liquidity is building on bank balance sheets) for those investorswithout liquidity issues this is a perfectly fine result as they have the opportunity to re-price the loans to current marketrates and significantly improve mark-to-market values. In addition, our PE speaker noted that the 10-15 largest dealsaccount for nearly half of the $300 billion coming due. There was a thought that perhaps given the recent run in theequity markets, it could be possible to spin back out these large investments as public companies and using theproceeds to delever (wiping out the PE sponsor investment). As for the remaining $500 billion of debt needed to fundPE buyout activity, the panel was confident that liquidity will flow towards where there is opportunity and these dealswill get funded; however the bottom line is a belief that the attractive investment environment will continue for sometime.
Final Tidbit: The Panel Was Unanimous in the View That Public Equity Markets Have Likely Overshot theFundamental Economic Trends and the Credit Markets are Lagging the Equity Euphoria.
Although this finalpoint has little to do with the state of the middle market, we thought it was interesting that all three speakers believedthe public equity markets were likely ahead of the economic reality over the next year. The unanswered question iswhether capital will continue to come off the sidelines to support the market until the fundamentals grow into themarket multiple...or will there be a pull-back? Unfortunately our dinner didn't solve that one.
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Things Starting to Look Up, State of the Middle Market Dinner
A Stifel Nicolaus recap of a dinner to discuss lending in the middle market and BDCs.
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