- May 28, 2015
Over the past year, and even more so in recent months, the middle-market mergers & acquisitions (“M&A”) environment has been characterized by heavy deal activity with abundant debt levels and upward valuation pressure. Average Total Enterprise Value / EBITDA (“Purchase Price Multiples”) has surged from 6.2x in 1Q2014 to 6.8x in 1Q2015. As valuations begin to increase, buyers tend to require greater debt loads at close to effectuate the transactions to ensure adequate equity returns. In addition, hot M&A markets typically see buyers contributing less equity as a percentage of total capital in the final capital structure. One would think that an increase in valuations / debt loads would present a great opportunity for mezzanine debt investors, however, in some ways it actually adversely impacts mezzanine lending. The considerations are further explained below.
Average total debt to EBITDA (“total leverage”) multiples have steadily increased over the past year from 3.5x in 1Q2014 to a high point of 4.0x in 1Q2015. This increase in total leverage has predominantly been from senior lenders increasing their leverage on transactions. As an illustration, the 3.5x total leverage in 1Q2014 was comprised of 2.3x senior debt and 1.2x mezzanine debt, where in 1Q2015 total leverage was comprised of 3.4x senior debt and 0.6x mezzanine debt. As with any frothy market, the more aggressive the senior lenders become, the less mezzanine capital tends to be needed in the capital structure. As senior lenders become more aggressive, typically a larger portion of their loans are uncollateralized (aka more reliant on cash flow to cover debt service payments). When the music stops and the economy starts to struggle, the senior lenders become more susceptible to losses because the cash flows from the Companies may not be enough to cover debt service payments and the collateral is not great enough to cover the principal balance of the loans. In summary, this is the cyclical nature of lending that always will affect mezzanine debt levels. When times are good, mezzanine lenders tend to get squeezed as senior lenders become more aggressive with loan amounts. However, once a recession or a softening market occurs, senior lenders begin scaling back on their total leverage which then provides a greater need for mezzanine debt to fill gap of capital needed to complete transactions.
Also, pricing is typically affected for mezzanine debt funds during frothy markets like the one we are experiencing today. For example, in 1Q2014, the average coupon for mezzanine debt was 12.1% compared to 11.3% in 1Q2015. We at FNB Capital have certainty seen firsthand a downward pressure on pricing in recent months as competition between mezzanine funds to put capital to work has intensified.
There are also different dynamics regarding total leverage as the enterprise values of a company become larger. For example, in 1Q2015, on average, companies with enterprise values between $10 and $25 million had total leverage of 3.8x (2.9x senior debt / 0.9x mezzanine debt), whereas companies with enterprise values between $100 and $250 million had total leverage of 4.3x (3.9x senior debt / 0.4x mezzanine debt). As companies become larger in size, senior lenders typically will provide increased amounts of senior leverage compared to leverage offered on smaller businesses. We at FNB Capital Partners typically focus on $10 to $50 million enterprise value businesses which allow us to invest in companies at lower leverage multiples. Our comfort level for total leverage resides around 3.5x for recent transactions, which provides our portfolio companies some flexibility during times of duress.
In summary, the cyclical nature of the M&A market will undoubtedly continue to affect mezzanine debt financing in the future. We at FNB Capital seek to provide unique solutions to businesses at reasonable debt levels and pricing. We try to avoid succumbing to the frothy market dynamics and attempt to maintain adequate debt levels that both us and the Company can be comfortable with. Even though the market has recently exhibited higher senior debt levels, we have still managed to put a considerable amount of mezzanine financing to work over the past twelve months.
*Source: Statistics are sourced from GF Data Resources quarterly M&A and leverage reports