Tom's two cents: leverage misperceptions in the middle market
For the past several years, most finance professionals in the middle market have concluded that fiercely competitive debt markets have been the primary driver of elevated enterprise values, as buyers access higher leverage at lower pricing to finance acquisitions.
However, in reality, an analysis of aggregate leverage over the last 10 years does not support the case. Instead, as the chart below illustrates, leverage numbers bump along with minor ups-and-downs along the way, but without any drastic abnormalities during that timeframe. In this piece, we will examine leverage numbers to figure out what has kept leverage in a reasonably tight band since the recession.
In this chart leverage is technically up since 2013, but only slightly. The more interesting data point to note, however, is that enterprise values (EVs) are now at all-time highs across all of Livingstone’s core sectors. So, if EVs are at all-time highs, in the case of leveraged buyouts (LBOs) where leverage is used to complete the transaction, shouldn’t Debt to EBITDA also be in the stratosphere?
In digging deeper, we can watch a trend begin and take hold – sponsors choosing to forgo leverage in many cases and using more equity upfront to complete a transaction. In fact, Refinitiv LPC, a financial data firm that tracks middle market transactions, has found that equity contribution has increased from 49% of total consideration in 2013 (includes roll-over) to 56% of total capitalization in the most recent quarter.
So while EVs have increased from 7.8x to 11x, equity capital is disproportionately accounting for the increased financing required to support these lofty enterprise values. One driver of this “over-equitizing” phenomenon is that sponsors are not looking to maximize total available leverage, rather, they are using all senior structures; senior stretch, and of course unitranche credit solutions, to lever the buyout. In fact, 2nd lien and Mezz are not common tools anymore, with mezzanine capital becoming virtually extinct ($1 billion of mezzanine has been issued in the first half of 2019, when historically mezzanine issuances were close to $1b per quarter).
These factors lead to a senior debt market correctly identified as fiercely competitive, as financing these over-equitized buyouts is actually less risky for the lenders. However, it is hard to detect just how competitive the market is when looking at the numbers in aggregate. I don’t believe there is a true debt ceiling where lenders are afraid to go past an absolute leverage number, nor do we think the OCC’s guidelines have significantly curbed leverage given Banks are playing a smaller and smaller role in leveraged buyouts. According to Refinitiv LPC, only 16% of LBOs were bank led during Q2 2019. Instead, we believe borrowers are actually using restraint when levering the buyouts out of the gate, and opting for all senior deals, senior stretch, and unitranche structures as opposed to Sr/Jr leverage maximizing structures of yesteryear.
Livingstone’s debt advisory practice continues to be the advisor of choice for both sponsors and family-owned businesses looking to access the global debt markets. With debt advisory professionals in both Europe and the U.S. our consistent volume allows us to stay abreast of the best pricing and terms the market has to offer and we would welcome the opportunity to work with you on your next capital raise.
