Mid-market leverage continues upward creep

Nicole Tovstiga
03 May 2018

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Private equity houses are pushing leverage boundaries once again, driven by high price tags for a limited number of assets and the fact that debt is readily available and cheap. Nicole Tovstiga reports

An increased acceptance and use of debt funds across Europe has contributed to a ballooning mid-market, as competition between banks and funds increases.

According to data by Unquote sister publication Debtwire Par, 48% of mid-market issuance – for which Debtwire has obtained a leverage metric – was between 5-6x levered so far in 2018, a significant rise from the 29% figure for 2017.

Private equity houses are being offered – and must subsequently compete against – some of the highest levels of leverage since 2007. Debt funds achieved a market share of 47% in Germany in the first quarter of 2018, up from 35% in 2017, according to GCA Altium's recent MidCap Monitor – and only 53% of senior deals were bank-only in Q1 2018, compared with 65% in 2017.

"Debt is a fierce competitor," says Louise Nilsson, CEO and partner at Stockholm-based private equity house Priveq. "We have competed in auctions against bidders with leverage [in their supporting debt packages] of 6-7x EBITDA for mid-market assets. For Priveq, with a clear growth agenda, we are not comfortable with too much debt.

"It is surprising to see the financing levels currently in the market. We've not seen leverage this high since 2007," says Nilsson, adding that the high evaluation multiples are, in general, supported by readily available debt.

It is surprising to see the financing levels currently in the market. We've not seen leverage this high since 2007" – Louise Nilsson, Priveq

While high levels of debt are more commonly seen in the large-cap space, the small-cap and mid-cap markets are being influenced by the biggest providers. "Larger transactions define the market and work their way down," says Rob Harris of Rabobank. "The debt levels and terms we see with the larger players in deals in excess of £40m EBITDA are coming down into the smaller deal sizes."

On one hand, with banks more than willing to provide financing, and debt funds more readily available, entering a situation with high debt can be risky and could restrict future growth, says Priveq's Nilsson. Although Priveq conducts traditional leveraged buyouts using debt, it tends to lean on the conservative side and typically leverages less than its peers.

On the other hand, the appropriate level of debt for mid-market firms depends on the size of the business and its sector. "Smaller businesses with £5-10m profit would normally see leverage of 2-4x and certain assets will see 5-6x in the UK market," says Shani Zindel, partner at Livingbridge. "It really varies. For example, a higher leverage level could be more appropriate for an IT company than a retailer."

Depending on factors such as the level of cash flow and income, some businesses can easily cope with 6x leverage. But Zindel does not see this as an appropriate level when leverage is used to drive a high price for businesses. "Corporate finance advisors may use the lender education process on a business in the selling process to set price expectations," she says. "Sellers and advisers can get an early view and use leverage to gain control of the business and drive the process."

Flexible terms
Mid-market covenants have been under threat for the past two to three years, but lenders are allowing even more flexible terms and, in some cases, wholly discarding covenants in competing deals. "A major difference during the past couple of years compared with the previous height of the lending market in 2006 has been the lighter financial covenants," says Johan Steen, partner at law firm White & Case.

On average, leverage/EBITDA levels in the mid-market are around 5.7x, compared with 5.6x in 2006, but the current financial covenant package is lighter and more borrower-friendly than in 2006. And while leverage levels climbed around the time of the financial crisis, loan agreements today are even lighter.

Floris Hovingh, head of Deloitte's alternative capital solutions team, has noticed an erosion of governance.

"It has become a more relaxed environment for sponsors to do what they want," he says. "Optically, it looks like leverage covenants are in place, but the reality is they are set with so much headroom and tested on artificially adjusted EBITDA. It will not bite when lenders need them."

A major difference during the past couple of years compared with the height of the lending market in 2006 has been the lighter financial covenants" – Johan Steen, White & Case

In the large-cap space, syndicated loans are typically cov-lite, and 75% do not have covenants. However, the mid-market may not necessarily follow and drop the leverage covenants, as end investors in debt funds have been promised covenant protection, Hovingh says.

The lighter covenant packages are a result of an increase in high-yield bond financing and the rise of alternative capital providers putting pressure on banks to offer more competitive terms. Says Steen: "All other things being equal, having a lighter covenant package means a company with the same debt burden should have an easier time dealing with its lenders if there is a downturn."

Covenant-lite packages may well make it easier for the borrower in a downturn, as lending groups will not be breathing down their necks, but it also means the lenders may not see the early warning signs of distress.

As the market puts increasingly more debt into companies, if things turn bad and performance decreases, it will be difficult for unitranche lenders to get to the table with a sponsor, given the relaxed, or even lack of a, covenant package.