As Credit Tightens, Entrepreneurs and Dealmakers Turn to Non-Traditional Lenders

After what occurred in 2000 and 2008, one should have expected banks and other common lenders to become more regulated and scrutinized. Though this may have created some inconveniences for some firms, it helped open the door for others. Banks have established more rigorous qualifications for companies to be given financing, and capital constraints and shareholder activism are becoming more influential when it comes to publicly traded business development companies (BDC). For middle markets in particular, this has allowed alternative lenders to emerge and acquire more market share than would otherwise have been possible, because of the vast amount of competitors.

“Banks have established more rigorous qualifications for companies…”

With public perception of banks still relatively low and regulators keeping a close watch, it is not difficult to see why banks want to keep a low profile and not conduct any business that may raise a red flag. In 2015, 25% of middle market loan transactions featured deals of more than 6x EBITDA; an example given by regulators as a possible red flag. It is why most traditional bank lenders are currently staying away from making leveraged loans deals on private equity firm deals.

Similarly, BDC’s are also currently sourcing fewer deals. They are currently facing difficulties in raising capital, because as of March, most were trading below book value. This has prevented many from issuing new equity for funding. Without cash to fund new transactions, the only alternative would be to fund from repayment on existing loans.

Collateralized loan obligation (CLO) issuances are on the decline. About $4 billion in CLOs were priced for what was most of the first quarter, a harsh decline from almost $17 billion during the same time period just last year. During 2013-2015, the CLO market grew by more than 50%. However, the market has decreased by about 50% during the past year. Additionally, under the Volcker Rule which is set to take effect at the end of 2016, managers will be required to hold 5% of their CLOs. Though many managers are attempting to adapt and others are selling off their CLOs, it remains to be seen how the rest of the market reacts.

Finally, we come to the benefactors. Alternative lenders are currently taking advantage of the current state of the lending market with great vigor. A great advantage they have is being able to act quickly and with much flexibility. This is possible, because most are either non-regulated or regulated far less than traditional lenders. These alternative lenders are beginning to develop close relationships with private equity firms for these particular reasons, which helps PE firms acquire financing for deals, and as a result fund the investments in their portfolios. Small Business Investment Company (SBIC) funds are also benefiting from the current state of the financing landscape, especially considering the two new regulatory changes made at the end of last year; reduced registration requirements by advisors and the amount of capital an SBIC can control has been raised to $350 million from $225 million.

Though the availability of attaining financing has become more difficult, not all have been affected negatively. The financing landscape will improve, but in the short-term, in its current state, we should expect alternative lenders to become more prominent players in the space.

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3Q 2015 Private Equity Environment

Global equity markets fell sharply in the third quarter, driven by concerns over slowing global growth, particularly in China, and uncertainty over the U.S. Federal Reserve’s monetary policy. The MSCI World Index declined by 8.3% in the third quarter, the index’s worst quarterly performance since the third quarter of 2011. Nearly every single-country equity index posted a loss, led by the Shanghai Composite, which declined by 27.9% during the quarter despite a raft of measures undertaken by the Chinese government to stem the sell-off. Other emerging markets and commodities also declined significantly, weighted down by fears of contagion and the knock-on effects of a slowdown in China. The S&P GSCI index, which measures a basket of 24 different commodities, declined by 19.3% in the third quarter, which brought the index to its lowest level since 1999.

Highlights

• Equity market volatility adversely impacted IPO issuance during the quarter. Global IPO issuance in 3Q15 totaled $13.6 billion, a 76.8% decline from 3Q14 and the lowest quarterly total since 1Q12. 
• Global buyout investment activity has increased only moderately over the past few years, and 2015 is on track to continue the trend. YTD 3Q15 buyout transaction activity totaled $289.8 billion, an increase of 2.7% over YTD 3Q14
• PE firms worldwide raised $58.1 billion in 3Q15, a 43% decrease from the prior quarter and a 31% decrease from 3Q14. The decrease was driven by buyout- and U.S.-focused fundraising activity

Private Equity Investment Activity
U.S. Buyout Investment Activity

U.S. buyout investment activity totaled $55.8 billion during the third quarter of 2015, down approximately 14% from both the prior quarter and the same period in 2014, according to data from

Thomson Reuters. This brought total U.S. buyout investment activity for the first three quarters
of the year to $190 billion, a decline of 5% from the same period in 2014. The year-over-year decline in investment activity is reflective of the increasing wariness of many general partners in the face of rising valuations in a competitive market environment. Many general partners are setting a high bar for new investments, which is restraining overall investment activity. The average purchase-price-to-EBITDA multiple (across all transaction sizes) for new buyout
investments was 10.3x for the first three quarters of 2015, up from 9.7x for all of 2014, according to S&P LCD. Although average purchase-price multiples are increasing, general partners continue to be disciplined and are structuring their transactions conservatively: the average equity contribution
rate for a buyout transaction completed so far this year is 40.8%, and the average debt-to-EBITDA multiple is 5.6x; the corresponding rate and multiple for all of 2014 are 37.0%
and 5.7x, respectively (see table 3).

Non-investment-grade debt markets were not immune to financial market volatility during the third quarter. The BofA Merrill Lynch High Yield Master II index generated a –4.9% return in the third

quarter, which drove an increase in its option-adjusted spread to 662 basis points over U.S. Treasuries—its highest level since June 2012. U.S. leveraged loan issuance totaled $115 billion in the third quarter, a decline of 14.8% from the year-ago period. Year-to-date 2015, U.S. leveraged loan issuance totaled $341 billion, a 24.3% decline from the same period in 2014. The decline in leveraged
loan issuance was due to a number of factors, including the slowdown in buyout investment activity in recent quarters, a shift toward more-conservative financing structures (which occurred as a result of the banking industry’s new leveraged lending guidelines), and the recent increase in credit spreads (which is tempering issuer appetites).

The largest announced U.S.-based buyout transaction during the quarter was the $12.6 billion acquisition of Oncor, a Texas-based electric transmission company, by a syndicate of investors including the Hunt Group, Avenue Capital, Centerbridge Capital, and GSO Partners. If completed, this would also be the largest buyout transaction of the year thus far. The investor group is acquiring Oncor from Energy Future Holdings, which is currently in bankruptcy court, eight years after its record-setting buyout led by KKR and TPG. Other notable buyout transactions announced during the
quarter include the $8.0 billion carve-out of Veritas from Symantec, led by Carlyle Group, and the $6.5 billion take-private of insurance software provider Solera, led by Vista Equity Partners.

Fundraising Market

Private equity firms worldwide raised $58.1 billion in the third quarter of 2015, a 43% decrease from the prior quarter and a 31% decrease from the $84.7 billion raised in the year-ago quarter, according to Thomson Reuters. The third quarter figure brought year-to-date worldwide private equity
fundraising to $246 billion, which is just slightly ahead of the $245 billion raised over the same period in 2014.

The quarter-over-quarter decrease in worldwide private equity fundraising was primarily driven by U.S.-focused funds, which raised $31.5 billion in the third quarter—a 58% decrease
from the prior quarter and a 44% decrease from the year-ago quarter. Significant decreases relative to the second quarter of 2015 occurred in each major strategy. After strong starts to the year for both U.S. buyout and venture capital fundraising, the strategies raised just $13.6 billion and $4.6
billion, respectively, which rank 33% and 24% below the average quarterly levels experienced for their strategies over the past five years. Notable U.S.-focused fund closings during the third quarter include American Industrial Partners VI, which raised $1.8 billion, and Insight Venture Partners IX, which held its final closing at $3.3 billion.

Europe-focused funds raised $19.9 billion during the third quarter, flat from the prior quarter but up 8% from the amount raised in the year-ago quarter. The primary driver of the region’s year-over-year increase was the growth in venture capital fundraising: the $3.0 billion raised during the third quarter was the highest quarterly total since the fourth quarter of 2008. Asia-Pacific-focused funds raised $5.9 billion during the quarter, an 83% increase from the measured second quarter; however, the year-to-date total of $14.7 billion raised in 2015 represents less than 50% of the corresponding 2014 total. The largest Asia-Pacific-focused fundraising round held during the third quarter was that of Chinese venture capital fund Shunwei China Internet Fund III, which closed on $1.0 billion. 

During the third quarter, buyout funds raised $30.3 billion, a 43% decrease from the prior quarter (or a decrease of 15% when excluding the $17.0 billion close of Blackstone Capital Partners VII in the second quarter). Fundraising within the segment was broad-based: nine buyout-focused partnerships raised $1.0 billion or greater, highlighted by EQT VII, which closed on $7.4 billion, the largest amount raised during the quarter. Fundraising for venture capital–focused funds remained relatively flat during the third quarter: the $9.9 billion raised worldwide represented a 5% decrease

from the prior quarter and a 5% increase from the year-ago quarter. The aforementioned decline in U.S. venture capital fundraising, combined with a greater than 70% increase in quarter-over-quarter fundraising in every other major global region, resulted in just 46% of the worldwide venture capital
fundraising total being raised in the United States—the lowest percentage raised by the region since the fourth quarter
of 2011.

Energy-focused fundraising experienced a significant slowdown during the third quarter, following three consecutive quarters of record-setting activity. Energy funds raised $5.5 billion, which represents a 27% decrease from the strategy’s 5-year quarterly average of $7.5 billion. Despite the decrease in overall volume, notable firms in the energy private equity space continued to accumulate significant amounts of capital following the downturn in oil and natural gas prices: Ridgewood Energy Oil & Gas III ($1.6 billion), Apollo Natural Resources Partners II ($1.3 billion), and ArcLight Energy Partners VI ($0.9 billion) accounted for 70% of the quarterly energy fundraising total. Fundraising for other private equity strategies (i.e., subordinated debt, infrastructure, and special
situations) represented 21% of the total amount raised during the third quarter.

Source: Pathway Capital, Bloomberg, S&P LCD. 

Note: Information contained herein has been obtained from sources believed to be reliable, but Redmount accepts no responsibility or liability (including for indirect, consequential or incidental damages) for any error, omission or inaccuracy of such information. The projections shown are provided for informational purposes only and should not be construed as investment advice or providing any assurance or guarantee as to returns that may be realized in the future from your private equity commitments. Projections and expected returns are subject to high levels of uncertainty regarding future economic and market factors that may affect future performance.Accordingly, such projections/expectations should be viewed as only one possibility out of a broad range of possible outcomes.

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Unlocking resources through better corporate cash management

Companies call on the full resources of their cash management, as they need to grow, execute CapEx or acquisitions.

But going an extra step gives financial managers a chance to help benefit their organization in a less-than-usual way.

The financial manager has an excellent opportunity to contribute strategically to a company's growth, by demonstrating how working capital can be leveraged to serve as a financing and risk management tool in conjunction with, or in addition to, traditional funding methods. This can help strengthen the capital plan and help improve the debt structure.

The benefits of freeing up cash to grow a company:

Reduced financing requirements

• Existing cash is typically the cheapest form of financing. Using it to finance growth, including for CapEx or acquisitions, can reduce the external financing expense of stock or bond issuance. 
• The cash released from
  
  working capital in this instance, should be valued at a weighted average cost of capital (WACC) or, alternatively, the cost of financing the growth should be included in the capital plan typically developed by the financial management team. 
• In the example above, established working capital standards, can guide a company to release a sizable amount of cash, which applied at a well structured WACC can generate benefit for the company.

CLICK HERE

Look out for financial ratios and credit ratings

• Credit rating agencies like D&B review company balance sheets. 
• Rating agencies usually look upon increases in free cash flow as a positive factor during this process; however, it’s important to note that agencies may penalize companies that ineffectively manage their working capital compared to their peers.

A positive impact on company strength and valuation

• When looking at a discounted cash flow valuation, the release of working capital that can be achieved by the company would translate as an increase in cash, ultimately improving the valuation of the company.
• This needs to be looked at carefully and conservatively to ensure that all improvements can indeed be achieved; the finance team is in a prime position to evaluate this.
• When using weighted average cost of capital, including working capital release in the calculation may boost a company's financials through a one-off increase in free cash flow.
• Although working capital is priced into a corporate acquisition, the full potential of the synergies often go unrealized when the treasury team, which handles working capital daily, isn’t involved early in negotiations.
• Working capital is often looked at with more detail in private equity deals, as it is the goal of financial sponsors to maximize asset allocation and drive quick shareholder returns.

More funds for growth

• Cash unlocked from working capital may help a company grow more quickly, facilitating integration and reducing the execution risk from a cash flow requirement perspective.
• Strategic events such as mergers, acquisitions, sales, reorganization, etc. provide the perfect opportunity to review the working capital position of the company. 
• Although the review of working capital and improved management of cash may require some efforts, (improve processes, deploy new banking solutions, and change policies), uncovering these funds can sometimes can release sizable cash to the company's balance sheet.

Released cash can add up quickly

Even a one-day improvement in working capital management parameters can have a profound impact and the finance management leadership plays an important role in this.

Working capital release techniques could be bank-led solutions such as factoring, supply chain finance and card solution, or internal re-engineering such as supplier and customer payment terms standardization. A centralized liquidity structure automated at an in-house bank level can also move the needle in terms of the funding mix of long-term versus short-term debt structures.

As another internal example, larger companies execute ‘payment runs’ on a weekly or fortnightly basis. As these payment files usually are designed to have all payments processed on that same day, the company often ends up paying invoices earlier than their due date (invoices due in the following

week or two) to avoid the cost of executing daily payment runs. Changing this process so that payments are ‘warehoused’ at the bank level until the invoice due date can be a quick and easy way to release working capital, often resulting in a three-day extension of Days Payables Outstanding.

The example above illustrates how the finance manager’s knowledge of the organization’s cash flow can help establish what the achievable extension of company's days payable outstanding is, and therefore, what the subsequent reduction in the cash conversion cycle would be.

Best practices to consider

• Involve finance staff as often as possible in to decision-making process.
• In M&A situations finance team can propose the use of cash from working capital as a funding option.
• Identify the focus areas for working capital release.
• Prioritize the deployment of processes and policies, which can quickly release cash from the working capital to accelerate the funding growth.
• Centralize treasury operations: consider using shared service centers to standardize payments flows and leverage funding from an in-house bank with automated cash concentration structures.
• Hand off functions to banks, such as the financing of some of the strategic suppliers through a supply chain finance program, or the management of some local processes (such as payment file translations).

Note: Calculations of Working Capital used for the examples in this document follow the bellow formulas:

Days Payable Outstanding [DPO] = (Trade Accounts Payable / Cost of Goods Sold) * 365
Days Receivable Outstanding [DSO] = (Trade Accounts Receivable / Revenue) *365
Days Inventory Outstanding [DIO] = (Inventory / Revenue) * 365
Cash Conversion Cycle [CCC] = DSO – DPO + DIO

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2Q 2015 Private Equity Environment

Market Overview
Global equity markets were rattled late in the second quarter with the prospect of a Greek debt default

and exit from Europe’s Economic and Monetary Union (EMU). On the second-to-last trading day of the quarter, following Greece’s decision to hold a referendum on the terms of a new debt bailout deal, the MSCI Europe index declined by 2.7%—its largest daily decline since October 2014. In the United States, the S&P 500 declined by more than 2%, which erased the index’s gains for the year. Asian
equity markets also sold off on the news, although most of the region’s equity indices finished the quarter with gains. Fixed income markets performed poorly overall in the second quarter. In particular, despite the commencement of the European Central Bank’s (ECB’s) quantitative easing program that drove much of the eurozone’s sovereign debt market into negative yield territory early in the quarter, euro-area government bonds experienced their largest-ever

quarterly loss, driven by concerns that yields had fallen too low in light of an improving economic outlook for the region.

Highlights

• M&A exit transaction value for PE-backed companies totaled $174 billion in 1H15—a decline of 34.8% from the record-setting 1H14 total but still one of the largest first-half totals ever recorded.
• High-yield default rates remain below historical averages in both the U.S. and Europe. However, sales of nonperforming loans reached a record high of €91 billion in 2014 and are expected to increase further in 2015.
  
• PE firms worldwide raised $92.1 billion in 2Q15, a 9% increase over the prior quarter and a 17% increase over the year-ago quarter. The increase was driven by buyout- and U.S.-focused fundraising activity.

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6 Lessons from private equity any company can learn (especially before selling)

Too Faced Cosmetics in Irvine, CA was sold in November 2016 to Estee Lauder Companies for $1.45 billion, almost for $1 billion more than acquired one year earlier by the seller, General Atlantic. 

General Atlantic, a New York private equity firm, acquired the business in 2015 from another private equity firm, Weston Presidio. 

Too Faced was co-founded in 1998 by Southern California entrepreneurs Jarod Blandino and Jeremy Johnson.

The founders sold Too Faced to Weston Presidio in 2012, for only $71 million.

How did Too Faced Cosmetics' value go from $71 million to $1.45 billion during the 2012 to 2016 period? 

There may be several explanations, but the key answer is in the way how private equity owned businesses are owned, managed, perform, and grow in value. 

Can we identify key factors why private equity owned businesses seemingly do better, at least for short- and intermediate-term, than their industry peers?

Consulting giants, led by Bain & Company, a successful private equity investor in its own right, offer a list of lessons any company can learn from private equity.

1. Define the full potential. The target is to increase equity value - how to turn $1 of equity value today into $3, $4, or $5 tomorrow.

2, Develop the blueprint. The blueprint is the road map for reaching your full potential - the who, what, when, and how.

3. Accelerate performance. This involves molding the organization to the blueprint, matching talent to key initiatives, and getting people to own them. 

4. Harness the talent. This requires creating the right incentives to recruit, retain, and motivate your best talent - and get them to think and act like owners. 

5. Make equity sweat. This calls for managing working capital aggressively, disciplining capital expenditures, and working the balance sheet hard.

6. Foster result-oriented mind-set. The goal is inculcate disciplines so that they become part of the company's culture and create a repeatable formula for achieving results.

Are the above 6 keys the reason why private equity owned businesses perform better than their peers over short and intermediate term intervals?

Private equity firms impose certain disciplines and models to force companies to succeed or at least satisfy their highly driven and monetary-oriented ownership. Companies are forced to immediately improve financial efficiency, performance, and continuity.

Well-placed partners of private equity firms serve as company ambassadors, acting as connectors to valuable contacts and strategic opportunities.

A study by A.T. Kearney (leading global consultancy) revealed the following:

1. Private equity owned companies generally outperform their industry peers, primarily in slow-growth industries, such as chemicals, large consumer goods and retail, manufacturing and business services.
2. Contrary to popular belief, PE firms that take on a supervisory role—giving the deal partner
   responsibility from acquisition through exit— deliver more value by balancing growth and profitability.
3. Success factors of PE firm models are transferable for those willing to learn.

Why private equity firms love cash?
PE players look at their balance sheet not as static indicators of performance, but as dynamic tools for growth. One critical component of this approach is to aggressively manage down working capital.

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"We love to discover companies with hidden gems like owned real estate which we can later sell and lease back, extracting our equity and reducing our base investment costs. It happens often and sellers could easily take advantage of these if they only reviewed their assets before selling to us." -  Mid-size private equity executive.

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Are high-yield bonds and floating-rate loans at risk?

The constant pursuit of yield in this low interest rate environment might have pushed the demand for high-yield bonds and floating-rate loans high enough to impact judgement of banks underwriting and backing new issues.

Banks are frantically underwriting high-yield bonds and financing syndicated floating-rate loans, counting on investors to absorb everything coming to markets.

Interest rates for new bond and loan issues have dropped, prompting borrowers do more acquisitions, buybacks. etc.

Private equity fund operators are some of the largest biggest users of high-yield bonds to arrange leveraged and management buyouts. Floating-rate loans are used in buyout deals as well.

Low interest rates, willingness of banks to underwrite bonds and loans, and readiness of investors to acquire bonds and invest in loans have pushed mergers & acquisitions and buyout activities to new highs. Valuations of companies being snapped up in auction style sales are breaking records after records, reminiscent of 2007.

The illustration to the left, a deal tombstone published in the Dow Jones Private Equity News, speaks to it. In this case, a large private equity and LBO operator borrowed $1.75 billion to supplements its own funds to acquire more companies. Keep in mind that acquisitions are done by issuing high-yield bonds, to add to the equity. As such, banks are lending loans to add to the equity of the buyer, all while still lending more via high-yield bonds. More leverage to execute more purchases. All loans and bonds will end up in investor accounts, through mutual funds and ETFs, in a very short order.

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U.S. cash balances remain high

Investors are continuing to hoard cash and keep more and more capital in short-term assets.

Source: Investment Company Institute data, Federal Reserve, and Bloomberg. *Total cash and short-term assets include money market assets (ICI), large time deposits, all commercial banks, NSA (not seasonally adjusted), savings deposits, and small time deposits.

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Is the Corporate M&A Bubble in Trouble?

We think its not...yet. The current level of activity suggests that corporate managers will continue to buy rather than build.

In a recent CNBC poll, some 56% of companies said that they plan an acquisition in the coming year, up from 40% last October and the first time since 2010 that more than half plan to do something. But even if such plans were to generate a surge later this year, it would make a bullish argument for equities, not the bearish one accompanying much of this recent buzz.

M&A, quite simply, is a vote of confidence in market values and the future generally. Companies buy each other when they see a reason to expand and when other firms look attractively cheap. The same goes for private equity, which is no less in the acquisition business than corporations. If these decision makers saw stocks as expensive, they would pursue their expansion with direct investments in new equipment, premises, and in a hiring program. Since they are buying these days and doing relatively little building, they have effectively announced that stock values still make a purchase the more attractive way to expand.

Table 1. M&A Activity (monthly rates)

Period	Number of Deals	Value ($ in bil.)
2013 4Q	817	$79.6
2014 1Q	959	$108.7
2Q	1,000	154.8
3Q	1,003	108.1
October	1,123	96.5
November	1,006	194.0
December	983	103.6
2015 January	995	$78.4
February	938	114.3

Source: FactSet

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The effects of bulging corporate purses.

High cash levels, accumulated by S&P 500 corporations, are being put to work. Above charts are showing growing levels of capital expenditures, M&A activities, dividends, and stock buybacks by the nation's largest corporations.

If sustainable, this will benefit the economy. Capital expenditures can add to the industrial growth. Dividends and stock buybacks will probably add to consumer spending and housing sector strength. Corporate mergers and acquisition activities may strengthen equity markets.

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