Shorter deals, more delayed draws

US mid-market private equity activity was robust in 2017, and the numbers show it. M&A EBITDA multiples in the US mid-market, defined as leveraged buyouts between $25 million and $1 billion, approached 10.7x, according to a third-quarter report from data provider Pitchbook, the most recent figures. This lofty multiple was attributed to high levels of dry powder and limited target companies.

Similarly, the same study showed a 13 percent year-on-year increase of US mid-market private equity dealflow in the third quarter of 2017 to $233 billion from the same period in 2016.

All of this has created intense competition in the private equity auction process, where deal timelines have been compressed from typically six months to 60 days from five years ago, one of The Riverside Company’s co-chief executives told PDI sister publication Private Equity International.

“Our clients still demand the same thoroughness of review, they just demand that it happen faster,” says David Nemecek, a partner at law firm Kirkland & Ellis who works on deals with private equity sponsors.

The effect has been not just on private equity firms, but on the direct lenders that will often bankroll a given sponsor’s LBOs, add-on acquisitions or any other transaction needing funding – therefore, sponsored finance in North America has been a hot place to invest.

PDI data show that private debt firms raised $180.1 billion in 2017. Some $60.1 billion of that was for senior debt, an area that has seen a lot of money flow into transactions involving private equity firms.

Twin Brook Capital Partners, which provides credit exclusively to sponsors, closed on $2.3 billion across a commingled fund and separately managed accounts in July. Antares Capital, also a sponsor-only shop, arranged a $1 billion SMA with the Virginia Retirement System. Both are likely to focus on North America.

The trend is not just evident in North America, but in Europe as well. Deloitte tracks alternative lending deals each quarter for the continent. In the third quarter of 2017, the most recent data available, of the 312 transactions done in the preceding 12 months, only 57 did not involve private equity sponsors.

Direct lenders are requiring less legal due diligence than in the past, one attorney says, explaining they are consistently relying on the due diligence the private equity sponsors prepare. The nature of today’s deal market has created more risk for debt providers, this person adds. There is less independent verification of the sponsor’s work or the credit firm’s own due diligence.

“Our clients still demand the same thoroughness of review, they just demand that it happen faster.”

David Nemecek

Private equity firms outside the massive alternative asset managers have begun hiring capital markets professionals. “We’ve seen capital markets professionals popping up at middle-market private equity firms,” Nemecek says. “Previously it was just the very, very large funds that would have dedicated capital market capabilities.”

“As full-time capital markets professionals at private equity firms become more common, you’re seeing more complexity in the terms of the financing and what the ‘art of the possible’ is, particularly outside the broadly syndicated credits.”

Settling for a draw

One fund manager notes the trend as well, explaining as a result, deal structures are “getting more sophisticated beyond the first lien-second lien” structure. This includes a rise in the use of delayed draw term loans, a sentiment echoed by others.

“The ask [for the delayed draw term loan] has increased and will probably continue to increase,” says Chris Flynn, chief executive of THL Credit. “If a direct lender has a way to structure it, it can help the direct lender win the deal.”

Private equity firms like that type of financing because it allows them to plan for future acquisitions, which is what delayed draw term loans finance. Less frequently, it may fund capital expenditures or other growth initiatives.

“Delayed draw term loans have been a feature found in middle-market financings more so than in broadly syndicated loans,” says Peter Nolan, a managing director at Antares Capital who heads the firm’s syndication desk. “It’s more common for middle-market LBOs to be a financing for a platform company that will grow through acquisitions [using the delayed draw term loan].”

To tap such a facility, the borrower must meet incurrence tests that are normally based on the portfolio company’s leverage level.

“Those have been fairly tightly negotiated,” Flynn says. “From a debt holder’s perspective, we would like to have the line not committed. People often ask to provide those with little no governors. It needs three to five provisions to get structured.”

Historically, the leverage levels governing access to a delayed draw term loan called for a slightly lower leverage ratio than that at the time of the LBO’s closing. That has changed more recently, with levels set at or near initial leverage not unusual, Nolan says.

“Even if you’re maintaining a certain leverage level, there’s a school of thought that says the larger a company gets, the more resilient it gets,” he notes. “The fact that it’s getting bigger is making some overall contribution to the overall quality of the credit.”

Twin Brook portfolio company Ivy Rehab Physical Therapy, a Waud Capital Partners-backed provider of physical therapy based in Harrison, New York, initially grew through acquisitions using a delayed draw term loan. That financing came as part of the $54 million Twin Brook provided to Waud in its initial LBO of Ivy Rehab.

“For the borrower, it represents a very attractive aspect to the capital structure. It has a modest availability fee, as low as 1 percent initially and then stepping up over time,” Nolan says, noting the delayed draw term loan principal amount is typically 20-25 percent of the funded term loan.

“The flip side is, from the lender’s point of view, they have to allocate committed capital up front because they never know when they are going to get the call saying some portion of the DDTL needs to be funded.”

For his part, Kirkland’s Nemecek has seen requests for such financings remain relatively flat, and only provided when there is an anticipated need for one. “I think [demand for delayed draw term loan commitments] is fairly deal specific and fairly constant. They are typically obtained with specific acquisitions in mind.”