April 2020 Debt Capital Markets Update
In the wake of Covid-19, liquidity is a common focus coming out of countless conversations with lenders, private equity investors, and owner-operators.
For many of us around the country, we are in week four of working from home. Lenders, private equity investors, and owner-operators have spent a good portion of the last several weeks on the phone – internally analyzing and evaluating risk in their portfolio and externally with suppliers, vendors, and customers.
Without a portfolio of our own to manage, we continue to schedule countless calls to keep a pulse on the various mindsets across the middle-market. The common theme coming out of our many conversations is a focus on liquidity. Depending on the situation, this focus has taken a handful of different forms.
Revolvers
An early response to the Covid-19 virus saw many middle-market borrowers taking the defensive and proactive step of drawing down their revolver to the maximum extent possible.
Delayed Draw Term Loans
Sponsors are reporting mixed success in accessing committed DDTLs for purposes outside those typically seen for these facilities. A handful of sponsors indicated they received permission to use DDTL proceeds to fund payroll and other expenses while their portfolio company is closed or operating at reduced capacity.
Amortization
Many borrowers approached lenders seeking a deferral of their March, and in some cases, March and June, amortization payments. In most instances, lenders have accommodated these requests. We have heard some reports of lender pushback on the request, particularly in situations where the borrower was already flush with cash but still took a full drawdown of their revolver. On a related note, lenders have pushed back more consistently on deferral of interest payments.
Expense management
As to be expected, aggressive expense management began almost immediately. Headcount has undoubtedly been a prime area of cost-cutting. However, for many companies, finding good talent has been such a challenge in recent years, it has been a difficult decision to let good people go. Another common theme we have heard is a broad range of businesses electing to forego rent payments while closed. Larger landlords, like REITs, have provided minimal pushback to these actions. Independent or “mom and pop” landlords have proven to be less accommodating. Further, payments to smaller or non-critical vendors will be delayed as managers continue to monitor their cash position closely. Lastly, growth capital investments planned for 2020 are being reevaluated to determine whether 1) the cash is available to fund the expenditures and 2) they are needed in light of the changing economic outlook.
Working Capital
We have heard several borrowers and sponsors express concern over the non-payment of accounts receivables. Businesses that continue to see demand for their products or services may experience a false sense of security as revenue and EBITDA hold up. However, as their customers and clients experience issues of their own, timely payment of outstanding or new invoices cannot be taken for granted.
Lenders own Liquidity
Lenders have been able to accommodate the rapid draw-down of revolvers without much issue. However, we have heard several instances where lenders have elected to remove themselves from new deal processes citing concern about their funding sources. This concern will be a topic to monitor as the crisis continues. Many lenders today use leverage lines to bolster returns. These leverage lines look through to the underlying health of the lender’s portfolio. Deterioration in the creditworthiness of a significant portion of a lender’s portfolio could impact the lender’s ability to fund new transactions.
Structured Equity
In our prior debt market update, we noted a high degree of marketing activity from structured equity funds. This increased level of activity has continued. Further, we have spoken with multiple sponsors historically focused on control buy-outs who are rapidly modifying their investment parameters to include greater flexibility in how they structure transactions. The opportunity for this type of capital appears to be two-fold. First, for good companies facing liquidity challenges but without incremental access to traditional debt, structured equity can be used as a lifeline. Second, as the fog lifts from the nationwide shutdown, concerned consensus indicates buyers and sellers may struggle to find common ground on enterprise valuations. Structured transactions may be a way to meet in the middle on valuation, allowing buyers to minimize risk in the downside and sellers to participate in the upside.
CARES Act
The recently signed legislation includes approximately $350 billion to support companies with 500 or fewer employees. Unfortunately, an area of uncertainty is whether private equity-owned companies will be permitted to participate. Our current understanding is that the SBA’s affiliate restrictions will require PE firms aggregate employees across all portfolio companies when counting employees, rendering many of them ineligible. The one counter to this though, is if a company has received financing from an SBIC-backed firm. PE firms should reach out to lenders and limited partners to determine whether any portion of their debt or equity funding has come from an entity that participates in an SBA program. On a positive note, we received communication from one of our non-sponsored clients that they have received loan proceeds from the Paycheck Protection Program indicating these funds are in fact flowing.
Overall, it appears middle-market companies moved quickly to shore up their liquidity situation. Companies that were fundamentally healthy before Covid-19 took hold of the economy appear as though they will be able to weather the downturn for the foreseeable future. However, businesses experiencing stress coming into this downturn will likely see an acceleration in difficult decisions and conversations.
Communication appears to be the key in this rapidly evolving market situation. Indeed, open communication between lenders on one hand and sponsors and management teams on the other has gone a long way in creating what appears to be constructive responses to this rapidly evolving market disruption.
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