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Insights into the Highly Competitive Debt Market of 2015

Joe Burkhart Saratoga Investment Corp. | April 23, 2015

The first quarter of 2015 is in the history books and has left many people scratching their heads, asking the same question: “where’s the deal flow?” As the person responsible for leading our firm’s business development efforts, I am particularly interested in the causes and effects of deal activity and other market conditions. Here are some of the facts that have caught my attention:

As of mid-March, data provider Dealogic tracked just $19.9 billion worth of deals globally, down 53% from $42.7 billion in the same period in 2014, and the lowest amount on record since 2002. The drop is particularly dramatic in the US, where deal making has only reached $7 billion for the year, about a third of the $22.1 billion a year earlier. The data is even more compelling when considering that 34% of the year-to-date volume in the US is attributable to just one deal: Bain Capital’s $2.4 billion secondary buyout of Blue Coat Systems Inc. The slowdown in M&A hasn’t only affected private equity sponsors — the slowdown also affects investment bankers, lenders, attorneys, consultants, and accountants.

The data is even more compelling when considering that 34% of the year-to-date volume in the US is attributable to just one deal: Bain Capital’s $2.4 billion secondary buyout of Blue Coat Systems Inc. The slowdown in M&A hasn’t only affected private equity sponsors — the slowdown also affects investment bankers, lenders, attorneys, consultants, and accountants.

To prepare for this column, I surveyed over fifty lenders ranging from banks, SBICs, BDCs, and hedge funds. The questionnaire contained ten questions and sheds a spotlight on the state of the middle market for lenders. The overwhelming sentiment from these lenders was that the quality of deals in the pipeline is “below average.”

When asked the quantity of deals in the pipeline, most lenders answered “below average.” Surveyed groups issued an average of 9 term sheets over the past 3 months. Most non-bank finance companies closed two deals in the past 3 months. Not a single survey participant responded that these levels were “above average.”

Here is some additional commentary from some participants:

How would you describe the current state of the debt markets? 

  • “Overheated with a paucity of ‘quality’ deals. As a result, acquisition and leverage multiples are being driven up to unrealistic levels. Broadly marketed M&A deals are just too pricey. We are focusing more than ever on proprietary deals (few and far between) and selectively non-PE sponsored deals. Too much debt and inflated purchase price multiples are not a good combination. I’ve seen this play before…and Lincoln still gets shot!” (Tom Neale, Patriot Capital)
  • “As a bank we still are experiencing an extremely competitive market. Non-regulated lenders know our constraints and can be more flexible on terms.” (unnamed executive at a middle market bank)
  • “The current debt market is intensely competitive with abundance of liquidity from existing lenders looking to put capital to work and a number of new participants entering the market all pursuing a fairly defined set of new debt deals. Unless you have an existing portfolio with good activity, lenders are willing to stretch on leverage and pricing for new deal originations. However, the leveraged lending guidance has created a bit of a ceiling at or around 6x total leverage so PE buyers are still facing a financing/valuation dilemma when properties are bid up beyond 10x.” (Nick Kilavos, Alliance Partners)
  • “Competitive; opportunities of any quality have multiple bank suitors. High quality deals coming to market are also able to negotiate better pricing with improved terms from senior lenders.”  (Peter Campbell, The PrivateBank)

What are you watching most closely in 2015? What do you think could help the debt market? What do you think could hurt the debt market?

  • “The private equity firm’s “value add” (strong industry focus with Operating Partners or Advisory Board bench strength) is more important than ever. What could help? A few BDC’s and unitranche finance companies driving up leverage to go out of business. Selective debt and equity markets amnesia is setting in once again, as it does every 5-7 years. We need a market correction!” (Tom Neale, Patriot Capital)
  • “Regulators continuing to tighten lending requirements for banks will have a major impact. Increased regulatory standards with regards to “highly levered transactions” could cause some of the excess liquidity and marginal players to come out of the market and result in more lender-friendly terms. On the other hand, if other opportunistic investors come into the market as a result, excess liquidity could continue, deteriorating underwriting standards.” (Rafael Castro, Enhanced Capital)

How does your firm try to distinguish itself from the competition?

  • “Simply stated . . . customer service. As a lender, we are often judged by the cost of our capital. People often forget that execution matters and you need to coexist with your capital partners post-closing. My job is to ensure that anyone working with our firm receives timely feedback, actionable term sheets, and access to deals and other opportunity flow that benefit our portfolio companies and their owners.” (Joe Burkhart, Saratoga Investment Corp.)
  • “Relationships, trust, execution, service, and market terms.” (Charles Davis, KCAP)

So what does all of this mean? First, it’s a great market to raise financing. A combination of low cost and borrower friendly terms and conditions mean that companies should take advantage of this favorable market. Second, really get to know all of your financing options. Traditional senior lenders like banks have become more restricted in the types of loans they can make and the types of companies they can lend to. Other non-bank forms of financing have proliferated since the credit crisis and companies need to know about all of their options. Third, not all specialty finance companies are the same. Get to know your potential partners. How have they behaved with other borrowers when bumps in the road are hit? Do they create value beyond providing capital? This is a market where everyone expects more. Expect the same from your financial partners.

Axial is the deal network for the middle market.

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