By: Dexter Braff
Will Mergers and Acquisitions Multiples Fall as Debt Goes Back to the Future?
Remember the run-up to the global recession when lenders were tripping over themselves to get in on a mergers and acquisitions climate that was positively giddy?
When debt capacity, typically expressed as a multiple of a company’s earnings before interest, taxes, depreciation, and amortization reached milestone levels, eclipsing the “6X barrier” (as coined by PitchBook)?
When the term “covenant-lite”, describing loan agreements with fewer protective covenants for the buyer and less restrictions for borrowers, became a thing?
When, flush with borrowing capacity, in order to secure the most attractive acquisition candidates, private equity pushed average purchase price multiples to almost ten times EBITDA?
And when, ultimately, faster than you could say collateralized debt obligation, it all came tumbling down?
Well, it’s beginning to look a lot like 2008 again.
According to an article published by Weil, Gotshal and Manages, in a hyper-competitive deal climate that has once again goosed purchase price multiples,
2018…saw a rise in leverage levels and the number of covenant-lite loans in the market. 73% of all buyout financings were leveraged at or above 6.0x and 41% were leveraged at or above 7.0x, which is the highest level seen since 2007. In addition, over 79% of institutional new issuance in 2018 was covenant lite.
But here’s the kicker.
As much as lenders have pushed the upper limits of debt capacity, it’s actually more than what these statistics suggest.
In an excellent piece published by valuation firm Murray Devein entitled, “Mathematical Sophistry: Aggressive EBITDA Adjustments Raise Concerns Among Creditors,” they discuss how “inflated” EBITDA calculations based upon a mix of overly aggressive historical and proforma adjustments have crept into debt capacity assumptions, effectively adding “a full turn or more in the total amount of leverage that supports a given transaction.”
In many cases, then, loans extended at 5-7 x EBITDA are really leveraged at a whopping 6-8 x, substantially increasing the risk of default.
To some degree, such credit terms have been justified by a rising economy and growth expectations tied to the Trump corporate tax cuts.
Perhaps.
But get a lender alone in a room with two fingers of Johnny Walker Black, you may well hear some version of, “If we don’t offer such generous terms, we’ll lose the deal to someone else. And if management executes on its vision and the markets continue as they are, we should be OK.”
And it will be (OK, that is).
If every assumption and variable in the financial models plays out just so.
Which begs the question: are we on the precipice of another market correction (which is financial speak for “crash”)?
And absent “cheap” debt (and the boost to returns that can be “manufactured” through leverage) will buyers, particularly private equity sponsors, be forced to reign in purchase price multiples?
Time will tell.
But you know what they say about history.
It has an uncanny way of repeating itself.