Sponsored Finance: On the rebound

If mergers-and-acquisition activity lives up to expectations, 2017 could be a very good year for sponsored financing deals in the private credit space – nearly nine in 10 private equity investors have an optimistic outlook on dealflow for their company. 
That number, 86 percent to be exact, comes from a Deloitte 2016 year-end report in which the consulting firm asked private equity investors if they anticipated their firm closing, on average, more deals over the next 12 months. This could be good news for private debt practitioners. 
“Private equity firms are absolutely tapping alternative capital providers,” says Jeff Hammer, co-head of Houlihan Lokey’s illiquid financial assets practice. “Private debt has become a more important component of middle-market capital structures than ever before.” 
This optimism comes after a drop-off in private equity deal activity in 2016 from a red-hot 2015, the largest post-crisis year by deal value. Private equity transactions totalled $336.73 billion last year, down from the more than $400 billion 12 months earlier, according to PitchBook research quoted in Churchill Asset Management’s The Lead Left newsletter.  
“I just think you’re going to see more M&A activity [in all sectors] than we have in years because all these key variables are coming into place,” says David Brackett, Antares Capital’s co-chief executive. “Ample liquidity in the credit markets, optimism regarding the US economy and a more business friendly tax and regulatory environment, plus companies’ financial results in Q1 and Q2 will compare favourably over those same periods in 2016.”
A robust M&A world would be a welcome change from 2016, which delivered weak syndicated mid-market sponsor financing activity, according to a Paul Hastings Q3 market outlook. 
The data, by Thomson Reuters, showed only $30 billion of syndicated sponsored mid-market loans were issued in the first three quarters. While Q4 figures have yet to come in, 2016 was on track to be down on a year earlier – there was almost $40 billion of mid-market sponsored loan issuance in 2015, the slowest post-crisis year.
Private debt firms also have a fair amount of capital ready to be deployed, even without raising more money – roughly $200 billion in dry powder, according to placement agent Asante Capital Group. 
A busier dealmaking atmosphere in the second half of 2016, combined with slower fundraising, resulted in a year-on-year decline in dry powder from $220 billion at the end of 2015. However, over a five-year period from 2011 the figure is up 50 percent.
According to Asante managing partner Fraser van Rensburg: “This generally reflects a rapidly growing asset class, with fundraising having outstripped deal activity in some years, but with some balancing taking place in other years, for example 2016, where the market soaks up the need for alternative sources of credit committed to the most competent lending managers in various markets.”
The amount of dry powder in the market will lead to “more hybrid deals”, says Bill Brady, a partner at Paul Hastings and head of its alternative lender practice. In those deals, banks provide the first lien debt, while alternative lenders provide the second lien debt, he says.
Most of those deals are done with companies which post between $75 million and $150 million in EBITDA, Brady adds. 
Brackett anticipates robust activity across other deal types as well. “In terms of Antares’ activity, we are seeing activity across all types of deals,” he says.
“Refinancings are on the uptick. People are looking at [the current] spreads over Libor against their existing spreads over Libor,” which may be higher.
“Add-on acquisitions continue to be popular among sponsors. More of them are going to the buy-and-build route because of the expensive M&A EBITDA multiples. [Recapitalisations] continue to be very spotty; loan investors turn to M&A first.”
Houlihan Lokey’s Hammer doesn’t see deal growth limited to one type of transaction; rather activity will grow across buyouts, add-on acquisitions and the like.  
“We are seeing increased activity across all types of deals,” he says. “I don’t think there’s any one specific deal type that has spiked over others. Right now the business world is full of optimism and potential.”  
Deal terms

As private debt matures, deal terms more common in large-cap transactions and those in the mid-market are blurring. The nitty gritty of transactions has changed both to the detriment and the benefit of alternative lenders, Brady says.

“The looser large-cap terms continue to come down market into the upper-middle market and sometimes the middle market,” he says. “We resist those terms, but with all lenders competing, it’s been to the benefit of the private equity firms, the fierce competition among lenders.”
The evolution of leverage covenants is an example of borrower-friendly terms. According to Brady, more deals now have a net leverage rather than a total leverage covenant. Under a net leverage covenant, the borrower can apply cash on hand to reduce its effective leverage as calculated by the covenant, he says.

Second lien lenders, which may be alternative lenders in a hybrid deal scenario, have benefitted from more favourable terms in an intercreditor agreement, setting out the liens and rights of creditors in relation to each other.

“The good news is we are taking historic middle-market second lien friendly terms in intercreditor agreements, to the benefit of alternative lenders, and moving them up market,” he says, explaining it comes to the benefit of alternative lenders who could write a bigger cheque in a large-cap deal.
Brady specifically cites provisions in an ICA governing the releasing of liens as an area where junior lenders are winning more protection. Friendlier terms could bolster a junior lender’s position if a deal goes sideways in a Chapter 11 case, a process in which creditors are paid according to their order in the capital structure: debt before equity, secured before unsecured. An advantage in an ICA could get the creditors a better negotiating position in the restructuring process. Those terms can also help in restructurings not taking place under court protection.
“Intercreditor agreements come into play in a bankruptcy but also a workout or restructuring,” he says. “It can dramatically impact the outcome of an out-of-court restructuring.”

Houlihan Lokey’s Hammer notes that M&A activity will have to adjust to the economic landscape. For one, the cost of debt could rise, partly as a result of increasing interest rates, though Hammer notes interest rates are still relatively low. 

“The deal-making machinery will accommodate the changes. We are still operating in a very low cost-of-capital environment. The positive deal-making environment will overwhelm in the short term the negative dynamic of increasing cost of capital.”