Of the many lessons private equity sponsors took away from the global financial crisis of 2008-2009, perhaps most indelible is the need for a long-term lending partner who takes a sound approach to balance sheet construction. Unfortunately for many sponsors, this lesson has come at a steep price.
During the depths of the last downturn, many were left stranded as a number of specialty lenders saw their credit lines non-renewed, portfolios reigned in and underwriting standards vastly restricted. Not only did sponsors face a lending freeze as borrowing capacity contracted, many also found themselves unhappily wed to new operating partners when lenders were forced to sell assets to service debt. Literally overnight, a relationship founded on nurturing support and a shared strategic vision degenerated into a transaction-based dialogue whose overwhelming focus became the delivery of quarterly results.
Today, as uncertainty has returned with a vengeance, sponsors can take comfort in knowing that a select group of prudently-managed lenders have heeded the clarion call from the Great Recession. Determined to steadfastly support their sponsor partners, this small circle has set out to transform their balance sheets—creating healthy structures capable of weathering practically any market condition.
Wanted: Lenders Who Take the Long-Term View
Why should private equity sponsors care about a prospective lender’s capital structure? Besides a strong desire to avoid a repeat of the 2008/2009 fiasco, sponsors have strategic imperatives as well. Most sponsors seek a lending partner who will look beyond the transaction at-hand and provide continuous financing through the life of the investment. This means helping sponsors realize the long-term vision for a portfolio company by supporting them through expansion and problem periods alike.
Such a “partnership” mentality also entails keeping some dry powder, or permanent capital, in reserve. In short, sponsors want a lender who will stand the test of time: one with the flexibility and wherewithal to offer a wide range of financing solutions, regardless of external credit conditions. Because this combination represents such a rare commodity—and since the cautionary tale of 2008 hasn’t been internalized by all—we’ve developed a checklist that sponsors can use to differentiate between proactive practitioners and potential repeat offenders.
Tread Lightly When it Comes to Leverage
Private equity sponsors in search of a stable, enduring lending partner with a fortress balance sheet would be wise to carefully examine several key indicators. First, closely scrutinize the use of leverage. Today—at an industry-wide average of 0.43x versus 0.69x—alternative lenders currently appear to have much lower debt to equity ratios compared to the beginning of 2008.[1]
However, in the absence of standardized definitions, a lender’s true debt to equity ratio can be elusive. For instance, stated amounts of equity cannot always be taken at face value. Instead, sponsors would do well to consider the underlying composition of such equity. Is all of it pure and unencumbered? Or, does it include alternative structures, such as collateralized loan obligations, which have some leverage inherently built in?
Similarly, some lenders maintain off-balance sheet obligations—such as total return swaps with daily mark-to-market provisions—that could adversely impact their capital position should the market move precipitously against them. These are just two nuances that can mask a lender’s true standing when it comes to leverage. When comparing prospective partners, sponsors should undertake thorough due diligence and ensure that comparisons are made “apples to apples”.
Look for Diverse Sources of Liquidity
More than the absolute level of debt, sponsors should gain an understanding of the tenor of a lender’s liabilities, how effectively its assets and liabilities are matched and whether it enjoys multiple pools of liquidity. During the previous downturn, a heavy reliance on revolving bank facilities with short maturities contributed to the liquidity squeeze. Today, well-positioned alternative lenders have established diverse pockets of funding ranging from secured/convertible term debt and SBIC financing to securitization financing and long-term credit facilities.
It behooves sponsors to pay particular attention to such diversification because it has a direct bearing on hold size—among sponsors’ key concerns. Though many lenders tout large numbers when discussing available capital, hold size is actually a better gauge of a prospective partner’s potential utility. A lender with $300 million in available capital becomes much less appealing if the firm’s hold size is a mere $5 million or $10 million. On the other hand, a lender with diverse pools of liquidity can use their ability to aggregate individual hold sizes across multiple facilities to provide more meaningful cumulative support.
Equally important is a clear emphasis on long duration debt with amortization schedules that do not result in large tranches maturing annually. By laddering liabilities, lenders mitigate the risk that large amounts of borrowing will simultaneously mature at an ill-timed moment. Today, for example, the average maturity structure among BDC’s is six to seven years, with some extending as far as eleven years.
Place a Premium on Permanent Capital
For sponsors in search of a strategic lending partner, capacity becomes crucial. A well-established lender who has demonstrated longevity and a critical mass of clients has most likely adopted sophisticated capital management strategies—maintaining some form of “permanent capital” to continually support its sponsors despite the vagaries of the market.
However, capacity is another metric that can be murky. When assessing total available capital, sponsors shouldn’t be misled by accordion figures that are often cited. Somewhat of a misnomer, accordions cannot be confused with actual, committed capital. A firm with a $300 million accordion credit facility does not necessarily have the wherewithal to lend up to $300 million. Rather, the accordion simply represents the ceiling, or limit, imposed on additional amounts of borrowing before the lender must go back for permission from its original facility partners.
In other words, a lender with a $300 million accordion can lend up to $300 million under that facility, provided the firm can identify other willing lenders to participate. Far from an automatic trigger for expanding committed capital, which is how the term is often used, accordions do not equate to actual capacity.
Fifth Street: A Paragon of Reliability
With low balance sheet leverage, diverse sources of funding, asset-liability matching and a generous hold size of up to $75 million, Fifth Street provides sponsor partners with constancy in a dynamic and ever-changing market. And, as credit conditions appear poised to tighten again, we remain particularly well positioned, having proactively recast our balance sheet to continually maintain significant, ongoing capital availability.
[1] “BDCs–Now Versus Then–The CEOs’ Views On Another Recession” August 17, 2011. Source: Wells Fargo Securities.
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