February 21, 2012
Interviewed by: David Snow
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Discriminating Debt

The financial meltdown evaporated many forms of debt, an inconvenient truth for buyout firms, which rely on debt financing to close deals and drive returns. But in the U.S. middle market, debt is still available for the right deals and sponsors, according to TJ Maloney of Lincolnshire Management, Terrence Mullen of Arsenal Capital Partners, and John Coogan of Duane Morris.

In “Discriminating Debt,” the experts discuss the state of lending in the U.S. middle market and the difference between cash-flow and asset-based lending.

The financial meltdown evaporated many forms of debt, an inconvenient truth for buyout firms, which rely on debt financing to close deals and drive returns. But in the U.S. middle market, debt is still available for the right deals and sponsors, according to TJ Maloney of Lincolnshire Management, Terrence Mullen of Arsenal Capital Partners, and John Coogan of Duane Morris.

In “Discriminating Debt,” the experts discuss the state of lending in the U.S. middle market and the difference between cash-flow and asset-based lending.

David Snow, Privcap: Hello and welcome to Privcap. I’m David Snow, co-founder of Privcap. Privcap brings you smart conversations about private capital.

Today our topic is all about the U.S. middle market. We have with us today three experts and veterans of the U.S. middle market. Joining us are T.J. Maloney of Lincolnshire Management, Terrance Mullen of Arsenal Capital Partners, and Jay Coogan of Duane Morris. Why don’t we get started?

A big and important aspect of the private equity middle market is debt leverage, and of course, most people think that the private equity industry started life called leverage buy-outs. And so clearly leverage has been a very important part of the business, whether it’s driving returns, whether it’s getting the capital together needed to purchase a company. What does the leverage – what does the debt market look like today for doing the kinds of deals that you do?

Jay, as you look across your clients, what are some important things for people to understand about the financing market that is effecting the ability of private equity firms do deals and to drive returns?

Jay Coogan, Duane Morris: For the clients we’ve been dealing with most recently – and I would probably categorize them in the lower end of the lower end of the middle market, the credit market has been good for them. They’ve been able to get credit. Maybe a little tougher analysis from some of their lenders, but the banks they’re going to, sort of the larger super-regional’s are willing to step in and make these loans. Obviously there are balance sheets and other issues. The credit markets are there for the size of deals they want to do, fifty million dollar and under, they’re there.

Snow: And you say it’s the same banks, the same kinds of institutions lending today that were lending prior to 2008?

Coogan: Roughly, yeah. There are a couple of new players, which is nice. Some people have kind of backed out of the space, but that’s a normal pruning and growth in a market in this case. Your senior lenders and more middle market deals, there’s been a natural turnover, but to a great extent, really the same players we’re dealing with since even 2009.

Snow: Terry, is that the experience of your firm as far as financing is concerned?

Terrence Mullen, Arsenal Capital Partners: It is. I think there is plenty of available financing for good deals, whether it’s a great deal or a good deal, at least you cut there. When the marginal deals are the ones getting crowded out, probably on the financing side.  So credit markets have obviously gone through a severe cycle. Nothing’s nearly to levels of ’06-’07, but  2010 was a pretty decent year, and 2011 is tracking around a similar level. So for high-quality sponsors, I think what really is happening is that lenders are choosing – are much more discriminating on the sponsor. Does the sponsor really know that space? What expertise are they bringing? What are the capabilities they have? How are they going to address the key risks? Do they fully understand those key risks, which lenders are always most concerned about? How do you mitigate those? And so we’re seeing capital available in general; however, we do see that better quality companies, better quality sponsors are getting better financing packages.

Snow: T.J., what is notable to you in your firm about the debt markets today?

TJ Maloney, Lincolnshire Management: Well, I think a couple of things.  First off it depends on what market you’re talking about. We’re primarily U.S. investors, but we do have some European assets, and of course the deal volume quarter to quarter in Europe is down 80 percent. That’s a very significant decline.  When we’ve looked at financing deals in Europe, we’ve heard things from U.S. banks, we don’t want euro exposure, which is kind of mind-boggling.  And a lot of European banks simply don’t’ have the capital to lend, so I think that if you’re pursuing European deals, you’ll see some very good pricing and some very good companies who may be facing a bit of a soft market for 12-24 months, but otherwise could be very good companies. However, the ability to get them financed is quite difficult no matter what the lenders say initially when you actually go to close. I think you may have an unpleasant surprise. U.S. market has been more selective. The lenders tend to lend less. We’re a value buyer, so we tend to borrow on a senior basis two to two and a half times.  There may be a market out there for four times, but I’d hate to be the one that was testing it. Then you can fill the gap with a little bit of mezzanine too, if that makes sense for you, and if that market is there for you.

Mullen: I was going to say on the growth side, where we focus a lot, really scaling businesses, we’ve found that lenders are more scarce there. The cash flow based lenders, there’s plenty of asset-based lenders, and I think those are loans that are being booked by big money center banks as well as regional banks.  But on the cash flow side, there is less capital in general. The firms are more discriminating about which deal, which sponsor, and just the leash is shorter. So when we lay out these growth plans, if we achieve certain thresholds, the lenders have given us more capital. We’ve had add-on acquisition facilities, which we haven’t seen for many years to do roll-ups or build-ups and buy-builds. But it’s with terms and conditions, and so in general, as T.J. was saying, the senior debt is at more moderate levels. We’ve used hybrid or structured or one-stop debt, and in some cases we’ll use mezzanine as well. One deal we did in April of ’08 when markets were pretty dislocated, we did a very mezz-heavy deal. Business with exceptional free cash flow, 70 percent, keep it down margins, and about a 68 percent free cash flow margins, and we did a deal that had two and a half turns of kind of structured mezz, which was kind of a hybrid mezz with only two turns of senior. So it is fairly deal-specific. But the cash flow type lending is the most scarce to find.

Snow: Well, if there’s less leverage in general – it sounds like you’re all saying that there is certainly leverage available for good companies and the right sponsor. But if there’s leverage available, how did that change the returns for buy-out deals, going forward? Wasn’t a lot of the return leading up to 2008 driven in large measure by the amount of debt that was able to be applied to some of these companies? I’m wondering if anyone has a view on that?

Mullen: I do. I would say it doesn’t – it changes transaction multiples first, so if less leverage is available, people can pay less, so you can address that to a ’06-‘07 where leverage was extremely cheap and abundant, so people paid bigger multiples. So multiples have contracted to adjust for that, and then it really is whether you say it’s an LP or GP issue, firms are determining what their appropriate returns are to do a deal.  So in general, when equity markets, say for the last five or six years, have been flat, and you’re looking for pension funds seeking to drive at least single digits – and many of them really say that honestly; it’s at least – we’re looking for a portfolio mid or higher single digits for a portfolio, which means that private equity has to deliver something higher. I think they’re realistic to understand that private equity is a more competitive space. Returns are going to be lower and have their cycles, but they’ve generally trended down over time, and so I think that firms and investors are more realistic about what they’re looking for, and I think that has caused some level of competition, but also some more moderate return expectations of investors has meant some firms are more willing to do deals in an honest case scenario in the low – low to mid teens.  Ten, 12, 15 percent type IRRs, and that’s where market clearing prices for lots of – I’ll say good or easy-to-do deals. So more complex deals. People have a higher return threshold, but that’s usually not as driven by leverage.

Snow: Again, returns in the private equity market, do you think they’re going to come down because there’s enough leverage available, or is it not that simple?

Coogan: Yes and no. It’s tough to get a lawyer to give you an answer these days. Obviously the great story is if you can leverage it up like crazy, everything hits, everything is perfect, nice flip, bang, what better returns. No leverage? You’re probably going to get less returns. That’s fairly simple. I think to Terry’s point, it’s bringing prices down a little bit because everybody’s borrowing it under the same conditions, and what it’s done is rewarded the better discipline P.E. firms who can pick the right – there’s even more of a premium on can you pick the right growth story, and then can you provide the operational support and expertise to make it happen, and your returns are going to come more on can you understand – pick, understand, and grow these businesses as opposed to how good are you at fast, financial engineering. Not that there isn’t a place for both in the private equity markets, and both approaches serve a purpose, but I think right now, there’s going to be a bigger emphasis on discipline and skill, and it’s going to be – might be a little market separation of these P.E. firms as they compete with each other.

Snow: I’d like to pick up on Terry’s shorter leash comment. T.J., is there anything different in the way that the lenders are being involved in the deal process and the level of invasiveness perhaps that they have in to wanting to not only take a very close look at the company that you’re buying, but take a look at the operations of your firm to see if you’re going to be able to execute on the plans that you’ve laid out for the investment?

Maloney: What we’re seeing is there’s been somewhat more of a return of the traditional lenders, and so relationships there are important to the extent they’re dealing with the money center banks. Prior to the last few years, you had so many hedge funds that it entered into the marketplace, and for private equity owners, it was somewhat of a scary thought because of such a trading mentality, the company gets off track and they really don’t have a desire to restructure, but really the knowledge or the mentality to restructure investments. So they’re a little more difficult to work with, a little less predictable. Lot of the hedge funds have exited the lending market, from what we’ve seen. And then what’s key in sort of a market that is more strict, if you will, from the lender’s perspective is relationships and history and what they’ve seen you do. They want to see a history of supporting companies. They want to see a firm that has the expertise to get companies back on track if they get off track.  So I think those are all important criteria for lenders.

Snow:  Terry, could you dig a bit deeper into the shorter leash? Are the lenders spending more time simply understanding the plans that you’ve drawn up for your potential investments?

Mullen: Yeah, very much so. The lenders, we like to engage them early in our process of sharing with them why we’re focused on which sectors, what are the trends or issues we see. They’re not often what the company presents.  It’s kind of our view of this market and our plan, and so that’s a plan that will kind of co-develop with the management team. What the strategy is multiple ways to win on the upside, mitigating multiple risks on the downside, and having the track record, as T.J. was saying, to do that. But they’ll dig – and we do, with these businesses, develop very detailed operating plans, identifying and lining up the resources prior to closing, get an agreement from management, these are the investments we’re going to make on our team, adding talent, what’s Arsenal going to do, what’s the management team going to do. So the lenders love to get into the details of those plans, truly understand the multiple levers we have to create value, and we find that when we go along in a transaction as we, every year, as we call it re-strap or re-strategize the business, and lay their craft. It’s usually about a two month process to develop a detailed operating plan around that, they really want to see that operating plan, not just what falls out the back end, what’s the budget. They want to see the operating plan that’s the financials, that’s the key strategic milestones, the key initiatives you’re investing in, and who are the resources to do that.

We found that when we do that, they’re much more willing to give us flexibility because of greater transparency, but they’re much more willing to give us flexibility to do add-on acquisitions, to do build-ups, to invest in new growth initiatives which are critical, investing in technology, R&D, globalizing many of our small businesses, and so as we get more latitude, I think with greater transparency and more detailed resource planning, we’ve been able to – they want to be knowledgeable and informed along the way, but we’ve got more flexibility to grow and scale businesses.

Snow: Well, there’s a lot more we can talk about with regard to the middle market. We can talk about deal flow, we can talk about the globalization of the middle market, but as far as financing and debt are concerned, I think we should pause here, but gentlemen, thank you so much for joining Privcap today.

Expert Q&A with Gary Levy, Partner, J.H. Cohn

Privcap: How do your clients understand the private equity opportunity?

Gary Levy, J.H. Cohn: I would say that we have a growth concept companies as clients or what I call ‘emerging concept companies, ‘and those are really ideal for middle market private equity funds because they want growth concepts. Our clients, they are unbelievably curious about the whole private equity arena. Who wouldn’t be? You hear all these stories about people getting piles of cash and what they do with that and the capital gain benefit of doing it. But do they know a lot about it? I don’t think so. I think that’s part of our job is to educate them on that opportunity and introduce them to the right private equity funds that would be a good fit.

When you’re talking about what that right fit would be, those are funds that financial capital, I think, is all equal. All these funds have lots of money. But what you really want is intellectual capital that you don’t have to grow your company. Intellectual comes with guys who have done it before. They get you the right team. They can show you, “This is where we go with the business. These are the right hires. This is how we structure this type of stuff.” I like to say that people have already made those mistakes.

Privcap: What do you mean by ‘growth concepts?’

Levy: One of the areas of expertise we have is in the hospitality in the consumer arena, so growth concepts in the hospitality arena are restaurant companies that are easily replicated, that the math works in terms of the investment to build the units and how quickly they pay back on that investment. You could take a company that has five, ten, fifteen, twenty units, and with the right financial and intellectual capital, very quickly turn that into 50, 80, 200, 300 and get to some point of an exit where obviously private equity funds really like that.

What’s that 5-year time horizon? When I’m introducing my clients to private equity guys, I say, “Yes, you’re going to like them. They’re very smart. But as they’re talking to you, they’re thinking down the road of who they’re going to be selling you to in five years.”

Privcap: Has capital become a commodity, and if so, what can private equity firms do to distinguish themselves in the eyes of business owners?

Levy: That’s a great question, and I don’t want to pigeonhole that all the – is the financial commoditized? There’s going to be differentiators, just staying on that topic, about how a private equity fund is going to present a deal. They’ll more or less be pretty close on valuation of the company, but how they structure that investment could be remarkably different. Some will let you take money off the table, some won’t. Others will want control of the board. Others will be the minority and let you do whatever you want.

To answer your other question about how can a private equity fund differentiate themselves? Again, they have to demonstrate intellectual capital in that industry that they can bring value added to the table. In the end, if they’re all the same from a math point of view, then it’s going to come down to, “Is this the guy I believe is gonna quarterback me and get me into the end zone in the long run?” I tell my clients a lot, when they’re looking doing a deal with a private equity fund – and we have several that talk to lots – don’t look at the valuation of the first offer. Look at the guy and say, “Who is going to be the one that’s going to really maximize the value of this company in the long run?”

That’s the bite of the apple you really want. The first bite is nice, but that second bite, that could be generational wealth changing events, certainly something that could be a legacy for the right type of company.

Privcap: How do investor introductions fit into the J.H. Cohn business model?

Levy: I think that’s a very unique differentiator between us and so many of the other firms out there. We work very hard to provide proprietary deal flow introductions to private equity funds that we know we work well with and we know that are the right match for our clients. That works pretty well because our clients are curious. They want to learn more about it. They want to meet these people. They don’t know much about the arena, and then we’re finding them funds that are really going to help them protect their business.

Getting someone to sell a business or take a new partner on, that’s like a child to these people, so it becomes a very emotional event for them. You’ve got to find them the right partners, people that are really going to have the same values and help you build something that’s great.

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