Week of Apr 11, 2016 
 
Where's the Deal Flow? (Second of a Series)

Last week we discussed the views of various private equity sponsors regarding the question of why the pipeline of middle market leveraged loans seems soft. Over the past several weeks, we've also had conversations with a number of key middle market debt arrangers and lenders. Their consensus mirrors that of the PE firms - deal activity reflects the kind of origination platform each player possesses.
 
For the top tier arrangers, deal flow seems to be down due to intense completion among these providers to underwrite lead transactions. With a paucity of new LBO activity in the first quarter, in order to lead a refinancing or recap a competitor has to take the deal away from the original lead arranger - a difficult proposition. 
 
For middle market loan buyers relying on deal flow from the syndicated loan market, the environment is challenging. At the lower end of the broadly syndicated market (issuers with Ebitda around $100 million) and at the upper end of the syndicated middle market ($50-100 million Ebitda), these firms compete with CLOs, retail loan funds, high yield funds and other institutional investors who are hungry for paper.
 
The typical outcome today, particularly with the more sought-after credits (what else should you invest in?), is that most investors will receive a very small allocation for their commitment. In many cases, this means significantly less than $10 million. It's hard to build a decent book of loans, one lender told us, on "one-sies" and "two-sies."
 
On the other hand, players in middle market club deals are having better success in seeing decent loan volume. This is especially true for those firms with strong private equity relationships and the ability to hold larger tickets. Sponsors are increasingly foregoing loan syndications to club up deals amongst their trusted debt providers.
 
The CEO of a leading middle market finance company told us recently that deal volume was certainly off market-wide in the first quarter, but that the smaller end of the middle market continued to show strength. "We are seeing good flow from our key sponsor relationships for issuers below $20 million in Ebitda," he reported.
 
Another senior middle market manager told us to dig deeper into the loan market statistics. "Some of the data out there is misleading," he said. "If you normalize activity by stripping out re-financings and recaps, and just focus on new LBOs, it's probably not as bad as it looks."
 
With that in mind, take a look at our Chart of the Week. Yes, new mid cap LBO volume held its own for most of 2015, but buyout loans did take a real hit in the first quarter.
 
Interestingly, add-ons represented a greater share of M&A related loans (41%) than for any quarter since 3Q 2013. Expect a future column to cover this trend.
 
Next week we conclude our series by examining PE multiples and exits, and whether they will contribute to improving middle market loan volume.

THE LEAD LEFT SPOTLIGHT

This week we chat with Stephen Lewis, Managing Director, Headwaters MB. Headwaters is a middle market focused investment bank. Steve's focus is cross border debt capital markets. 
 
The Lead Left: Steve, it's been over two years since we last spoke. What's changed since then?

Stephen Lewis: The world is not the same place we knew even two years ago. Just look at Europe and see how the lending community is in the process of being re-made. In the US, lending to the middle market has been historically  dominated by non-banks. In Europe it has been just the opposite.  Now, as a result of regulatory pressures and public backlash, the European banks have had to scale back leaving a wide open opportunity for new market entrants, mostly non-regulated "alternative" lenders, to come in to fill the void. 

TLL: What's been the impact of all this regulation from a competitive perspective?
 
SL: Basel III, and the effect the US Dodd-Frank rules have had on the off shore operations of US banks, have created a very different playing field. New direct lenders, such as finance companies, have popped up in a wide variety of shapes and sizes. These include private equity, hedge funds and even family offices. This is a real sea change for the European marketplace. These players, like the pension investment community, are all looking for ways to generate consistent returns. And they're all called "debt funds," but each is different from the next.
 
"Regulation forces commercial finance lenders to provide formula-based asset-based loans and shy away from 'air balls'."

TLL: Which drives us crazy. These different risk profiles shouldn't be lumped in the same basket.
 
SL: But all of them have to underwrite the risk of getting their principal and interest paid back consistent with their risk appetite. Because they are not all homogenous "debt funds" or underwriting risk the same way, it takes time to know "how they tick". But these alternatives allow borrowers more choices when picking a lender to customize a financing to more closely fit their needs. For these new lenders, the consistent returns generated by the loans keeps their investors happy. In some respects, you might say this is a win-win for the middle market. 
 
TLL: Is lending in the wine drinking countries worse than lending in the beer drinking ones?
 
SL: I wouldn't say lending in the wine drinking countries, meaning Southern Europe, is "worse." Lending there has challenges not found in Northern Europe. The secured lending rules, laws, customs and practices are more creditor friendly in Northern Europe which means "alternative" lending has grown there first. That region is slightly ahead of the curve, but even now Southern Europe recognizes now's the time to take advantage of the market opportunity.
 
TLL: Are bankers getting educated on these challenges?
 
SL: The World Bank has recently asked the Commercial Finance Association to provide training to governments and local country lenders on the benefits of secured lending and how to go about setting up a secured lending scheme that works for all the stakeholders.
 
TLL: Why the World Bank?
 
SL: Because the middle market drives the European economy - as it does here. Think about the similarities: both the US and Europe have roughly the same populations, the same land mass, and the same size GDP. All of the middle market companies in Europe, just like those in the US and the rest of the world, need the same access to capital to fuel their economic engines. With the banks pulling back, it is in the best interest of the World Bank and the central European banks to explore innovative ways to provide alternative sources of capital. Secured lending is demonstrably effective in helping middle market companies grow.
 
TLL: What's your view of middle market lending appetite among the European banks?
 
SL: The so called "clearing banks- banks like Lloyds TSB, RBS, and HSBC being British examples, and their equivalents in other jurisdictions - need to put €25-50 million to work per deal and for regulatory and other reasons are not really looking to move down market. For this reason RBS and other clearing backs have set up commercial finance lending arms so that they can address the needs of the middle and lower middle market.  However, many of those commercial finance lending arms will only provide true asset-based loans on a traditional formulaic basis. They're shying away from "air balls" for regulatory compliance reasons.
 
TLL: Are banks focusing on sponsor finance activity?
 
SL: The large commercial banks clearly like sponsored transactions and continue to court and support the financial sponsor marketplace. But regulation has clamped down on their ability to provide higher leverage. So the rules of the game have changed. For classified leveraged loans, banks must post more capital, which affects credit criteria and returns. That causes banks to make leveraged loans to their most credit worthy clients. 

To be continued the week of Apr 18

Contact: Stephen Lewis
slewis@headwatersmb.com

Tipping Point
 
Danny Meyer startled the restaurant world in October with a dramatic announcement-he was eliminating tipping from all his Union Square Hospitality Group fine dining locations. 

Many revolutionary ideas seem obvious in hindsight. This one is being launched against a firmly entrenched practice that defies common sense yet remains the economic foundation for many service sector employees in the United States. 

The reaction on op-ed pages was favorable, thanks to Mr. Meyer's sterling reputation among cuisine cognoscenti. Since launching the Union Square Café in 1985, he has consistently been on the forefront of restaurant trends, propelling him to the role of industry statesman.

It is also a campaign years in the making, dating back to Meyer's partnership at Gramercy Tavern with chef...
 
Click here to read Randy Schwimmer's 
MidPoints column in the latest issue of Middle Market Growth magazine.
CHART OF THE WEEK
Buyout Blip

Pure middle market LBO activity slumped during the 1Q 2016, while add-ons were a greater share of M&A loan volume.

Quarterly Middle Market LBO and Add-on Loan Volume
Sources: : Thomson Reuters LPC 2Q MM Investor Outlook Survey
STAT OF THE WEEK

LOAN STATS AT A GLANCE
Provided by:



Contact: Timothy Stubbs
MIDDLE MARKET DEAL TERMS AT A GLANCE
  Provided by:

 April Update



Contact: Stefan Shaffer
LEVERAGE LOAN INSIGHT & ANALYSIS
Provided by:
2016 DIP loan issuance has already surpassed last year's total

Debtor-in-possession loan volume reached US$1.6bn in 1Q16 across 5 deals. That number already surpassed 2015's entire total of US$930m across 4 deals. And there is more to come. Peabody Energy announced it had secured an US$800m DIP financing from creditors as it filed for Chapter 11 bankruptcy. The deal includes a US$500m term loan and US$100m letter of credit, along with a US$200m bonding accommodation facility. Prior to the filing, Peabody had a roughly US$2.8bn loan across a US$1.65bn revolver and US $1.18bn term loan B. According to LPC Collateral, 108 U.S. CLOs hold a combined US$293bn or 24% of Peabody's existing term loan. While the majority holds less than 1%, there are 14 CLOs where Peabody's position accounts for 1% to 1.57% of the current principal balance. DIP loan issuance has largely been muted during the recovery years, only totaling US$11bn for the years 2013-2015, with Texas Competitive Electric Holdings' 2014 DIP loan comprising roughly 40% of that. More DIP loans are expected this year due to the weakness in the energy sector.


Contact: David Puchowski
MARKIT RECAP
Provided by: 
 

When it comes to the Italian banks, pessimists are not in short supply. Indeed, to be bullish on this sector could be considered contrarian, or even foolhardy, given its parlous state.  Asset quality is the overriding problem - Italy's banks have €360bn of non-performing loans on their balance sheet, about a third of the eurozone's total.
 
Nonetheless, there were tentative signs this week that optimism is returning as markets reacted positively to new supportive measures announced by the government. A €5bn fund called "Atlante" will be created, with funding provided by the country's strongest financial institutions. It is being presented as a private sector initiative, though the state-owned lender Casa Depositi e Prestiti is also contributing. EU laws on state aid have proved to be a stumbling block in the past, but the Italian government must be confident that their small stake in the fund will be overlooked by Brussels.
 
The fund will be used to underwrite banks raising equity capital, as well as buy junior tranches of NPLs under the government-backed scheme launched earlier this year. In addition, measures to accelerate the foreclosure process - a major impediment to NPL valuation - and plans for a well overdue consolidation in cooperative banks rounded out the government's efforts to fix Italian banking.
 
The big question is: will it work? The initial market reaction suggests that it may be a step in the right direction. CDS spreads in Monte dei Paschi Siena (MPS), the country's most troubled bank with over 30% of loans non-performing, tightened from 590bps to 520bps. Unicredit and Intesa Sanpaolo, Italy's largest banks, also rallied.
 
The latter move is somewhat surprising given that both banks are the largest contributors to Atlante - about €1bn each. It increases their exposure to the weakest borrowers in Italy at a difficult point in the credit cycle. However, the scenario of possibly multiple bank failures if clearly the most damaging for the whole sector, and if the latest measures help stave off such an outcome then it is beneficial for financial institutions both large and small.
 
It is easy to be cynical about Italy's banks, and it is not hard to fund reasons why this latest effort to revitalise the sector could fail. The size of the fund is dwarfed by the scale of NPLs, and the considerable difference in the book value of the loans and their market value could create more holes in banks' capital positions. But, for now at least, the optimists are having their day in the sun. 

Contact: Gavan Nolan
THE PULSE OF PRIVATE EQUITY
Provided by: 
 
 
98% of U.S. PE Funds Closed in Q1 Either Hit or Exceeded Target

In the first quarter of 2016, 71 U.S. PE funds closed on a total of $51.8 billion in capital commitments. Of those 71 vehicles, no less than 98% either hit or exceeded their target. This proportion is unprecedented, even by the standards of the past two years, and is surely due in large part to timing. Looking at the array of funds that closed, the success rate makes more sense: L Catterton Growth Partners III, One Equity Partners VI, Advent Global, Thoma Bravo, etc. These are all prominent, large PE firms that have a long, robust track record, which doubtless affected the quarter's results. But that alone can't explain why so many PE funds hit their targets. In addition, PE fund managers are adapting their raising strategies to an intensely competitive dealmaking environment, gearing toward less expensive opportunities in select niches with potential for considerable adding on and operational enhancements. Even though a considerable portion of the funds that were closed were in the billions of dollars and focused on buyouts primarily-hallmarks of the traditional PE strategy-there were a fair number in the lower size range, geared toward the lower reaches of the U.S. middle market, with firms like Pfingsten Partners closing vehicles with a specific focus toward niche manufacturing, distribution and business services companies. That same increased specificity is also reflected on the fund investor side. Limited partners are seeking out fund managers that can provide increasingly customized options, whether fee discounts, longer lifecycles, separate accounts or co-investment opportunities, to name some of the more popular embellishments. All in all, the ramp-up in bespoke LP agreements and niche buy side strategies are doubtless behind not only the increase in fundraising success over the past two years but the staggering rate observed in Q1 2016. Even if the success rate doubtless slides as 2016 goes on, it's testament to how the PE fundraising landscape continues to evolve.

Contact: Garrett Black 
SELECT DEALS IN THE MARKET


 
 

This publication is a service to our clients and friends. It is designed only to give general information on the market developments actually covered. It is not intended to be a comprehensive summary of recent developments or to suggest parameters for any prospective financing opportunity.

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