Leverage Remained High In Third Quarter by BMO Harris Bank via PitchBook
The third quarter continued to follow trends from previous periods, with leverage remaining at historically high levels. Maximum leverage in the quarter reached a 2015 high of 6.6x, and average leverage for all deal sizes remained above 5x for the sixth straight quarter.
While the senior multiple in transactions with both senior and mezzanine debt has remained relatively consistent, the senior multiple in transactions with only senior debt continued to increase. In fact, the delta between the senior multiple of senior only versus transactions with senior and mezzanine debt widened to more than one half of a turn of leverage. Earlier in the year the delta was consistently less than one half of a turn of leverage. Additionally, the larger companies were receiving more aggressive capital structures as debt levels were higher for companies with greater than $15 million of EBITDA.
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Speculation surrounding the Federal Reserve’s plan for a possible interest rate increase is causing significant disruption in the larger market, where pricing drifted higher throughout the third quarter. In contrast, the middle market saw limited fluctuations in pricing, due mainly to the unique club-like atmosphere in today’s middle-market leveraged industry. The middle market continues to price risk in the mid-5 percent range (Libor+450/1 percent Libor floor) as liquidity remains high.
The large market has seen a number of deals with price flexing upwards to levels over L+500 and closing fees widening to the 95 to 98 range. Arrangers struggled to sell the entire deal at the proposed terms and “the last institution to buy the debt prices the entire transaction.” As expected, middle-market OIDs have held at 99. Additionally, the lack of syndicated deals has led private equity groups to acts as arrangers and prevent issues such as flex as they arrange the deal well in advance of closing, thereby mitigating market volatility.
Use of proceeds
Middle-market deal flow continues to lag prior-year volume with most estimates showing year-over-year declines of at least 20 percent. BMO’s deal flow, while down, has exceeded the market’s performance and showed a decent rebound in the third quarter with year-over-year volume down only 6 percent. Future deal flow could show some effects of sellers’ hesitancy to be brought to market amid the continued volatility in the world today, especially deals executed in the large market. While liquidity remains at an all-time high, the potential for market disruption from a multitude of factors creates the potential for hung deals or shifts in terms that can work against sellers.
LBOs as the primary use of proceeds continues to drive the majority of transaction volume year to date. With deal flow picking up and many lenders having mined their portfolios for refinancings and dividend recaps, LBOs should represent the majority of the upcoming financings.
Purchase price multiples/equity as a percentage of purchase price Purchase price multiples increased for the third straight quarter, reaching 9.74x. The data continues to illustrate the imbalance between equity dollars waiting to be invested versus middle market businesses for sale. In addition, the inconsistent quantity of transactions, range of quality of businesses and the sellers’ expectations for transaction value has led to some erratic behavior and the continued growth of purchase price multiples. As if that weren’t enough, the aggressiveness of strategic acquirers has created a frothy environment in some auctions, as over 60 percent of the private equity exits in the first half of 2015 were sold to corporate buyers. We have lost a number of portfolio accounts up for sale to corporate buyers.
Equity as a percentage of the capital structure remained at 40 percent on average for the second quarter in a row. At this point in a cycle, it’s typical to see leverage increase and equity contributions decrease. While lower equity has been an indication of future problems in previous cycles, the level of equity being contributed in 2015 — while on a slight decline — is still significantly above levels seen at the peak of the last cycle. Also, the current percentage is more typical of actual levels seen toward the beginning of a cycle versus the end. In short, we are not seeing financial engineering creep into the market just yet.
The collateralized loan obligation (CLO) continues to be the vehicle of choice for many of today’s debt buyers in the leveraged finance industry. There are over 300 different active CLO managers buying leveraged loans in 2015. While projected to be 20 percent lower year over year, CLO issuance in 2015 will still be the second-largest on record (2014 being the largest).
2015 has proven harder for first-time managers to raise money as investors prefer to fund seasoned managers. Many predict that risk retention rules — which take effect at the end of 2016 — will lead to a decline in both the number of CLOs and dollars raised by CLOs going forward. It would require $21 billion of capital to meet the risk retention rules based on CLO volume outstanding.
BMO has raised approximately $1 billion of capital across three CLO funds, which have invested over $1.3 billion in loans since December 2012. The funds invest primarily in senior-secured, middle-market, floating-rate loans where BMO also maintains a loan position on its balance sheet. While CLO issuance has soared since the previous cycle, BMO continues to be one of the few players capable of raising CLOs solely dedicated to the middle market. The vast majority of the CLOs raised today are seeking opportunities in the larger — and more liquid — broadly syndicated segment and are restricted from participating in the less liquid middle market, except for a small allocation within their CLOs.
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