Debt 2014

Debt is poised to play a pivotal role in the performance of private equity. Our panel discusses the outlook for PE debt pricing, availability and covenants in 2014.

Privcap: Joe, how are private equity deals being financed today?

Joe Burkhart, Saratoga Investment Corp: At Saratoga, we focus on the lower end of the middle market, which we define as business- es with less than $10 million in EBITDA. And the main thing we’ve taken note of particularly this year is the lack of available senior bank financing for that part of the market. So if you looked at deals maybe four or five years ago that would rely on traditional bank that more and more they’re now turning to firms like Saratoga and Monroe to provide non-bank financing.

Privcap: Why are the banks withdrawing from that part of the market?

Burkhart: If you look at the statistics today, there are fewer banks than at any time in the history of the United States [since they began keeping records]. You’re seeing regulatory frameworks being put in place that make it too expensive to exist as a small bank today.

Ben Marzouk, Monroe Capital: Some of these banks are not playing in the lower end of the middle market because they like size. They’re risk averse and they want to make sure that they’re lending to companies that have stability. Usually stability equates with large companies, so they do feel uncomfortable leveraging up smaller companies But one of the things that’s going on today is that while some of the banks have left that mar- ket the number of [Business Development Companies] has tripled over the past couple of years.

Privcap: Ben, is there a company size that is the dividing line for certain types of financing?

Marzouk: We see the dividing line as probably 12.5 to 13 million dollars in EBITDA, why that line exists I’m not really sure. But most finance companies or banks feel comfortable lending, lending to companies in excess of $15 million dollars in EBITDA, which creates a nice market position or a nice market for BDCs like Saratoga and Monroe.

Burkhart: It’s also based on revenue. If you have a business with less than $30 million, you really have to search around for traditional financing.

Privcap: Let’s talk about covenants? Are they required? How many of them and how big a loan should you look for if you want fewer covenants?

Burkhart: The terms and conditions have never been lighter, [not] since the last credit cycle. Most of the covenants tend to focus around total debt to EBITDA fixed-value coverage, and a book value test. There are all sorts of other covenants used, but those are probably the three main ones that we utilize. And while there are covenants, there are also covenant waivers. We’re constantly being asked to amend when a borrower misses. And we’re more happy to do that when there is a technical default versus a payment default. But that’s happening, nonetheless.

Marzouk: For the smaller end market you are going to have … three or four covenants because they are smaller and you have to monitor them and watch them a little bit more carefully. Once you start getting above that $13 to 15 million in EBITDA, everything is different. In the second half of 2013 you found that [sometimes] there will only be one covenant. And that’s usually a net total leverage covenant. And that’s the only thing they can implement at this point in time because it’s so competitive out there. Everybody has to put money out there.

Privcap: M&A activity was down sharply in 2013, how has that affected lending conditions and what do you predict will happen in 2014?

Marzouk: Right now, everyone is fighting for the same deals. Once there is a good deal out there everyone is willing to lend and willing to compromise on terms and conditions. If they can’t compromise on terms and conditions they’re certainly com- promising on their interest margin and pricing on the deal.

Burkhart: A lot of the activity from this year was also refinancing, which isn’t really good for anyone in this industry because it means your pricing goes down. And so while you did see a flurry of activity a lot of that was just re-pricing of debt that already existed.

Marzouk: And in addition to a lot of dividends being taken out, a lot of [recapitalizations].

Privcap: What are the challenges facing private equity firms? Is there an uptick coming?

Marzouk: As competitive as our world is, their world is just as competitive. [For] a lot of PE firms, multiples for companies with, say, 25 to 50 million dollars EBITDA is increasing tremendously. Some of the large companies go for ten, eleven [multiples]. So because that market is so competitive, they’re coming down into the smaller market, the sub-15 million dollar EBITDA market. [So for] the smaller PE firms that usually play in that market, it’s becoming more competitive. They’re willing to pay a larger premium than the smaller guys, and that’s causing the multiples to go up and the pricing to go up. I think that 2014 will continue to be a pretty good year given what we see right now. Most of the M&A investment bankers are talking about good deal flow… so I think the first half of [2014] will be pretty decent as compared to last year.

Burkhart: This is about as hard of a private equity environment as I’ve ever seen. Today, [at closings] it’s less ‘great job guys’; it’s ‘let’s go do the hard work’.