What Growing Debt Spreads Mean for PE Dealmaking

As the leveraged loan market tightens, private equity dealmakers are being forced to ask an uncomfortable question—should I pay in cash?

Of course, no one would suggest we’ll be taking the phrase “leverage” out of “leveraged buy out” any time soon, but using higher-cost junior debt—or replacing it with something else—may very well put a dent in returns.

Year-to-date, total second-lien loan issuance volume has dropped 73% to USD 792m, while the first-lien issuance decreased about 31% to USD 48.5bn, according to the data provided by S&P Global Market Intelligence Leverage Commentary and Data (LCD) unit. In addition to new issuance, the data includes new-money refinancings but no repricings, according to the LCD analyst who provided the data.

“The price for second-liens was around Libor + 700 bps a year ago and now you are seeing deals at L+1000 bps, L+1200 bps,” said an executive of one of the largest business development company (BDC) in the US.. “The spread [between the first and second lien] has widened to the point where sponsors are better off putting in more equity and having an [all first-lien] capital structure,” he added.

Some of the recent deals where sponsors provided more equity are Apollo Management’s acquisition of Fresh Market last month that was financed with 43% of equity. This was higher than the average 38.5% equity check written by the sponsors in 1Q15, according to Thomson Reuters LPC data.

The firm’s earlier acquisition of the previously-unaffiliated Apollo Education Group was an all equity transaction, according to a press release.

Apollo declined comment.

Banks – that would traditionally syndicate both first- and second-liens – are not willing to commit to the junior piece of financing leaving the sponsors “dialing for dollars” or clubbing up to provide it themselves, in lieu of putting it more equity. This both reflects the market conditions, as well the more stringent regulatory guidelines for leverage loan lending that were put forward by the FDIC, the Office of the Comptroller and the Federal Reserve in 2001 and updated in 2013 and 2015. The rules are designed to ensure sound underwriting practices given “tremendous growth in the volume of leveraged credit” since the issuance of the original guidelines.

The difficulty in finding adequately-priced second-lien paper increases the execution risk of a deal and puts pressure on returns,  said a New-York based principal at a multi-strategy private-equity firm. Finally, from the lenders’ point of view, the lack of cushion in the form of subordinated debt could mean the first lien lender “will absorb a greater portion of the loss” in the event the credit becomes distressed, according to a 21 April Moody’s report titled “US Leveraged Finance: First Lien with Less to Lean On: Riskier Credits, Weaker Protection Will Hasten Distress.”

Financing new deals with first-lien unitranche structure, however, does come with its advantages, the BDC executive continued. Among these, is a simplified capital structure with no intercreditor agreement and typically lower cash flow expenditures for the sponsor.

However, there are limitations based on the amount of leverage desired.

“[Sponsors] always try to find an optimal capital structure for a particular company. However, when you need 5.5x of leverage you are just not going to get it the first-lien market,” said the principal.

Overall, while both second- and first-lien issuance is down, that does not mean there’s a lack of capital for good companies with well-structured deals. Buyout dry powder has risen by USD 18bn from December 2015 to USD 477bn at the end of 1Q16, according to Preqin’s 1Q16 Quarterly Update on private equity.