How does this make sense?

Armhoo1's picture
Armhoo1 - Certified Professional
Rank: Senior Baboon | banana points 208

Read this article on Bloomberg recently.

https://www.bloomberg.com/news/articles/2019-01-04...
Basically, lending standards are so loose right now that private equity sponsors can sell off collateral, or even isolate assets intentionally as to be out of reach from creditors in the event of default. Covenants have become useless, given how weakly they're structured. LBOs, by definition, means minimal equity.

BUT, if you're a small time entrepreneur, you have to pledge all business assets, sign unlimited personal guarantees, and that's after having substantially more skin-in-the-game than a financial investor. Arguably, small businesses are more productive for the economy than LBOs. They create jobs (even if owners are employees), are more community-oriented, potentially better customer service, locally based, etc.

Maybe this is one of the reasons why income and wealth inequality are big and growing problems. Also, what's the typical leverage of an LBO (in terms of equity % or EBITDA multiple)?

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Comments (6)

Jan 5, 2019

Sounds like it would violate capital adequacy constraints.

Jan 6, 2019
Armhoo1:

Also, what's the typical leverage of an LBO (in terms of equity % or EBITDA multiple)?

Depends on the industry, but generally banks will provide financing commitments with a 30-35% minimum equity cushion, sometimes you might see 25% minimum equity or up to 40% if it's a shitty business. As a multiple of EBITDA, again depending on industry, it'll usually be around 5.0x all the way up to 7.5x these days, with the bulk of them falling within the 5.5-6.5x range.

Also, to your main point - small businesses & startups are highly volatile in terms of cash flows and there is a substantially high risk of not being able to meet their interest/mandatory principal repayment obligations. This is in comparison to LBOs, where the companies are generally large, mature-stage, with predictable cash flows, and as such lower risk presented to the lender. Banks know that barring a calamity the cash flows of the LBO target will be able to service the debt; the same cannot be said for small businesses and as such the entrepreneurs must provide substantial collateral.

You're seeing everything issued cov-lite these days in part due to the continued strong performances of businesses (as well as some strong-arming by sponsors obviously), which has meant these covenants are not needed to mitigate risk for the lender.

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Jan 6, 2019

30-35% may not include mezz debt, so actual equity would be more like 10-20%.

To be clear, when I say small businesses, I mean traditional ones (not tech start-ups with zero revenue with expectations of being acquired). In that case, I feel that the mom-and-pop owners would give 200% effort to see their businesses succeed. Obviously, the loan amounts are smaller too, so that alone is lower risk to lenders.

Even though many LBO targets have predictable cash flows, the fact that there's so much leverage, means that even a small disruption could cause a business to be vulnerable. Some PE shops focus on distressed and turnarounds, but I'm not sure what the quality of cash flows would be like in those cases.

Lastly, as far as cove-lite goes, I don't think it has to do with business performance. I'm back in school right now, but I was previously working in LevFin. Based on my experience, debt markets are so competitive right now that lenders have to reluctantly agree to terms that could come back to bite them in the ass. Eventually, the pendulum will swing. After all, that's how cycles work, right?

Jan 8, 2019
Armhoo1:

30-35% may not include mezz debt, so actual equity would be more like 10-20%.

The commitment papers I've been seeing are all 30-35% min equity on 1L/2L or 1L/bond structures, generally have not seen much in the way of mezz debt recently. Given how expensive assets are these days, a lot of the time it ends up being a lot of an higher equity % than that. Have seen assets trade for 14x with 7x leverage, meaning 50% equity. Think the mezz stuff comes into play more frequently in MM/LMM deals which I do not particularly deal with, so to that extent you may be correct.

Armhoo1:

To be clear, when I say small businesses, I mean traditional ones (not tech start-ups with zero revenue with expectations of being acquired). In that case, I feel that the mom-and-pop owners would give 200% effort to see their businesses succeed. Obviously, the loan amounts are smaller too, so that alone is lower risk to lenders.

Not sure I agree that effort plays into the implied risk of a loan. PE investors are equally as motivated to see their investment be successful because it means more carry, and conversely a stinker of a deal could see a partner get the axe. And yes, the loan amounts are smaller in absolute $, but so are the lenders. Bulge bracket banks are not underwriting loans to small businesses, regional and community banks are. Without seeing the numbers, I would strive to say capital allocation per financing as a % of the lender's total assets is probably similar.

Armhoo1:

Even though many LBO targets have predictable cash flows, the fact that there's so much leverage, means that even a small disruption could cause a business to be vulnerable. Some PE shops focus on distressed and turnarounds, but I'm not sure what the quality of cash flows would be like in those cases.

I think again this depends on what segment of the market you're looking at. The smaller the company, the more volatile revenues are as a rule of thumb. I wouldn't agree that small disruptions in a large-cap LBO would expose a debt investor, these guys run a ton of sensitivities and look at the downside case with much scrutiny, and generally these issuers do not default unless there is a market catastrophe or they are over-levered.

You're not going to see revenues seesawing up 24% one year and down 15% the next in a large-cap LBO. With my father being a small business owner himself, I can attest to the year-over-year volatility of cash flows. Hence, I completely see why a lender would require much more to de-risk their loan to a small business rather than for an LBO. Correct me if I'm wrong, but isn't the statistic that 80% of small businesses fail within 5 years or something along those lines? This is the concept behind size premium when calculating your cost of equity.

Armhoo1:

Lastly, as far as cove-lite goes, I don't think it has to do with business performance. I'm back in school right now, but I was previously working in LevFin. Based on my experience, debt markets are so competitive right now that lenders have to reluctantly agree to terms that could come back to bite them in the ass. Eventually, the pendulum will swing. After all, that's how cycles work, right?

Agreed here hence my comment on sponsors strong-arming, competition has been fierce amongst lenders with a lot of unregulated players ala KKR, Antares, Ares, Golub being able to provide extremely aggressive terms. That being said, I do believe covenants have in some part also been rolled back by the lack of necessity for them in recent years. But, I think you might be more familiar here given your previous LF experience.

Jan 9, 2019

This is a great comment. A few other points are:

1) PE does a lot of deals and the leverage of future fees/revenue for lenders helps with terms

2) Equity going in behind the debt always helps and new money is better than old (e.g., I'd rather have a PE fund put equity in behind me with an incentive to get it back plus a return than just assume the business owner I'm giving a bunch of cash to will bust his ass for me when he's been pulling money out of the business for [x] years)

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Jan 9, 2019