Vito (00:07):
Hello and welcome to Strategic Alternatives, the R B C M and a podcast. In each episode, we explore the trends shaping tomorrow's global mergers and acquisitions landscape. I'm Vitos Peduto, head of global m and a at R B C Capital Markets. And as always, I'm joined by Larry Stein, deputy Chairman of Global Investment Banking. Today we have two special guests, Harold Vera, co-head of Global Financial Sponsor Coverage, and John Conos, global Head of Leverage Finance and Capital Markets. This is the second part of our discussion regarding trends that we're seeing in the private equity and leveraged
finance markets and how they're impacting deal flow in general. Guys, let's jump right back into it. I think as we look forward to the remainder of this year and going forward, beyond that, we're sitting in a pretty interesting time right now. We've got the SS and P and the Dow certainly at 52 week highs and approaching the highs that they reached towards the end of 21. There's been a rate hike recently. I think there's a general sentiment in the market that maybe the Fed has done, which gives people some confidence that they can predict how it looks going forward. Why don't we start, Harold, maybe get a view in terms of how you think deal flow is going to come about in the second half of this year. What types of transactions do you expect and is it the second half of this year do you think it's going to take longer?
Harold (01:33):
Thanks Vito, and thanks for those remarks. And not only do our clients probably think that the Fed is done or hope that they're done, I think there's a growing conviction that we're also heading for soft landing. So you can't really answer a question about sponsor's conviction around new deals, deploying capital in large amounts and wadding into this market, especially at reasonably high valuations as you mentioned, without also talking about the macroeconomic climate and outlook. And I think there is a growing sense that 2024 could be a pretty hopefully quiet and constructive tone to actually do deal
making. We talk about this first half of the year, which kind of went by so quick and we had a major bank failure. We had a mini regional banking crisis, and so you never know when curveballs are going to come. But to your point, the private equity industry, these investors are incredibly creative and they're going to continue to be creative and find ways not only to get deals done, but to also monetize those assets.
(02:29):
And on the deal making front, you asked what types of deals do I see happening? I really do believe that with the macroeconomic outlook improving with a stronger leveraged finance market. On the syndicated side, it's incredibly resilient market, both loan and bonds, and John will talk a little bit more about that with rates tightening hopefully. In terms of coupons for the best quality, I really do expect us to see a tremendous, I don't know a tremendous, but there's certainly a reasonable amount of take privates in the next 12 to 24 months. And I really do think that you're going to see corporates continuing to build war chest and divest assets that they've deemed non-core, even if they've been sitting on the
sidelines waiting at some point they're going to come out and we're starting to see some of that happen. Assets where the corporates have, it's been part of their portfolio for almost decades in some cases. And finally this is the moment where they say like, you know what? I know there's a private equity bid, let's go.
Vito (03:25):
I do think the market right now is much more accepting of those divestitures, especially if it can be portrayed as allowing you to focus on the core business from a go-forward perspective. And so no longer does it have to be divesting an asset that purely is a positive in terms of how it looks going forward. You can sell assets that maybe are lower valued and don't return as much, but you'll get an uptick from a valuation perspective because you've refocused the brand. Maybe John, pivoting to you, what types of deals are getting financed as you go forward to the remainder of this year and as you go in
the next year? You've talked about different levels of the capital structure and how do you see a constructive market coming together?
John (04:10):
Great question, and Harold, to your point, the Fed basically remove the recession from their case, so I think that's as clear of a signal you're going to get from them around their view of the world. They've been wrong before, they have been wrong before. Just to be clear, transitory inflation, transitory inflation. I think the markets like investors played it too safe at the beginning of the year because they didn't know where the world was going, and I think they're looking to play catch up right now, Vito. And so when we were looking at industries and accessing financing, I think investors wanted to stick to what they knew, which are very predictable, non-res, recessionary, durable businesses that could withstand
the shocks that they thought were coming down the road. And as I think we get to a world with some more stability, I think investors are going to want to diversify into industrials.
(05:00):
I think look at the Univar L B O we did for Apollo this year. We underwrote that Harold at the same time when that banking crisis was emerging. And I think we all took a gulp around what's the world going to look like in the summer around a chemical distribution business? And I think we were smart in that risk assessment and the markets want to be in that kind of investment as the economy is going to grow, and I think that means they'll take on more cyclical risk, industrial risk, healthcare, consumer, et cetera, versus sticking to things that were infrastructure, durable, predictable. And so when you look at the markets right now, the loan market's returned over 7% year to date. I think a lot of investors have been
playing it safe in that marketplace and now are looking to catch up for the rest of the year.
(05:46):
And in the high yield marketplace, that market also is up over 7% and so investors are looking to play catch up. They're also going to be careful to not make credit mistakes. So a credit right now in this market, and we always say this and leverage chance credit's important, but also having a view around where the puck is going in terms of investments and not being just so cautious. And as we get into 24, I think when you look at where cost of capital has anchored right now the high yield index is at 8.5%, the loan index is actually at 9%. Those are great entry points for investors and I think as they see the fed saying there's not a recession in their outlook that equity markets are stabilizing, they're going to be
very eager to deploy capital and we think that that's going to be a big part of the financing solutions that will lead to more deal creation.
Harold (06:33):
The one question I have on deal type of deals, Vito to your question, what we're going to see is the secondary, the sponsor to sponsor transaction that's been so prevalent for so many years selling from one to the other. I've seen years where it's as high as 40% of the overall sponsor deal volume and there's been a lot of reticence on the part of sponsors to continue to do those in the last 12 months, a real drop off in those secondaries. I think a lot of that's coming from limited partners who are looking for the sponsors that they're putting most of their capital into, not to be more creative and not necessarily just buy from other sponsors. I've seen that kind of stop a bit and I'll tell you it's a big area where the
private credit market has played kind of backing sponsor companies and then traveling into the next sponsor. And so as John kind of starts to talk about the different type of markets available on the debt side, I'm interested to see what happens with the secondary
Vito (07:32):
Harold. How do you think the size of transactions plays into that? Because we've certainly seen some larger deals happen over the last couple of years and those become a little harder as they've grown in the portfolio to sell to a sponsor and they're looking for either a strategic exit or a public market exit to be honest.
Harold (07:51):
And they can't count on the strategic exit as much as they'd like to. These sponsors are going to need a functioning I P O market regardless of sector. It's not just going to be a tech and healthcare exit.
Larry (08:00):
John talked about how attractive rates are for people wanting to put money to work on that side, and Harold you mentioned limited partners. Speaking of limited partners, the fundraising environment for sponsors has been a little bit weaker. On the one hand, I think some observers just say, well, that's natural. We talk about trillions of dollars of dry powder all the time and it's been a slower deal environment, so maybe the sponsors haven't been able to put that dry powder to work.
Harold (08:26):
I think we do have to understand the fundraising environment as we think about the deal environment and activity picking up because sponsors are going to want to very much monetize those assets that they have in their portfolio, recycle that capital back to the limited partners at hopefully good returns. How do they do that? They sell to strategics as we just mentioned. That's difficult, but when it happens, it can be incredibly lucrative. Other sponsors we just mentioned that hasn't been in vogue, if you will, as much as it has been in prior years. The I P O market where we've just seen a tremendous falloff in new issuance versus 2021, those factors are causing a bit of a backlog. And so what's happened, well on the fundraising side over the last few years there's been a 35% drop in the time between successive
fundraisers because they've been deploying so quickly and in 2022 the average fund ask what they put on the cover of their raise was 50% higher than the predecessor fund.
(09:19):
So not only has the ask to these limited partners come at a increasing pace, the size of that ask has increased. And so what we've seen in the last year is a drop of about 15 to 25% of actual targets being hit. And so there's been a pretty material, if you talk about a 25% falloff in funds raised, that's pretty meaningful in the last year. And it's not just for the larger funds or the smaller funds. There's certainly winners and losers of course as there always are, but often the first time fund has definitely struggled, but even some of the larger private equity funds have not been able to hit their targets. So it's kind of affecting everyone and I think that's the real question that I have that will eventually work itself through and we will see return to capital and we still the fundraising environment improve, but I think we're
going to be in a bit of a different spot for some time because that flywheel to get it kind of back moving, it's going to take some time.
Vito (10:17):
I mean Harold, we talked about a couple of years ago the fact that the concentration of fundraising, especially among the more significant LPs, was really going to the largest funds out there because again, they were looking to put larger dollars in one place and they were also looking for more co-investment opportunities. Do you think what you just described as a driver of those LPs starting to go back to a more distributed set of funds and going to a broader audience versus concentrating in the larger funds?
Harold (10:46):
I don't actually necessarily, I actually think that it's just really a consequence of them having less liquidity. I don't think the thesis has changed. I think they're still going to go make those betts on a fewer amount of sponsors and make 'em bigger. And so I think what you're going to have is you're going to have certain sponsors who just haven't been able to have that top quartile, top decile performance really struggle to raise funds of consequence and it's never a good thing when your successive fund is smaller than the prior one. I think we're going to see some of that.
Larry (11:17):
So John, what do you see to the biggest risks to the credit markets right now? We seem like we've had repair and leveraged finance markets, we're seeing an adjustment in a way to a new normal. What do you think are the things that could slow us down heading into the presidential election year?
John (11:34):
My biggest concern is the strength of the consumer. And right now the G D P number that came out today showed a very strong US economy, but our economy is driven by consumer consumption and as student debt repayment starts to pick back up and we exhaust savings, that's where we can see a little bit of a falter. So that's something to keep in mind that could cause default rates, which is what really affects the leveraged finance markets to tick up so far over the last 12 months with this higher rate environment that we've been in, we haven't seen a big pickup in defaults. We've been predicting it, but
we haven't seen it and that's pretty
Harold (12:11):
Remarkable.
John (12:12):
But we also haven't lived with five and a half percent rates for a long time yet. It's been half a year. It's going to be probably another year of this, so that's where we'll watch to see where there are cracks in the armor. And related to that, I think one thing Harold we should talk about in deal formation is the direct capital market, which again here to stay it's been 30%, it's been more robust lately. I think we view the direct market as a good tool for sponsors. I think it's appropriate where middle market lending has kind of fallen away from the banks where we really don't want to be portfolio managers, we want to be capital distributors. And so direct lending I think is a great vehicle for that. I think in the institutional market, what was interesting two years ago for direct lending versus our market was the cost of capital.
(12:59):
And when you looked at a fully flexed cost of capital from an institutional deal, it was more expensive than the direct capital transaction. That was a zero rate environment. Now we're in a five point a half percent fed funds environment, and so the coupon for direct deals hasn't changed very much. It's still a S O F R 6 25 to 6 75 product, but the all in capital cost has gotten much more expensive, so our financings become more attractive even on a fully flexed basis relative to that cost of capital for direct deals. We think that will show deals coming back into our market. Emerson's a great example where
that was underwritten with a direct component that we refinanced in the high yield market in the spring, but I do think the direct deals are good for middle market and I also think they're good for standalone financings.
(13:40):
If you have an investment where it's a roll-up or acquisitive, there's a lot of things to buy in the industry. It's more aptt for a institutional deal than a direct deal. But if it's a standalone thesis, I think the direct deal if cost of capital is not important is a viable tool. But also remember back to your equity point, Harold, that when you want to go for an I P O with a portfolio company, these direct deals I don't think are very attractive to equity investors as a cost of capital. So you'll see direct deals get refinanced to improve the cost of capital for the equity market.
Harold (14:07):
No conversation around deal making is complete without talking about private credit. To your point, it is here to stay. I think it and the syndicated leverage finance market are going to coexist and coexist well, and to your point, I think we're going to have a little bit of a rebalancing. I think there's been a pretty remarkable growth in that asset class over the last few years. I think that will normalize and certainly deals that in the last 12 months that you and I have said, hmm, it's interesting that we're actually getting a chance to underwrite this transaction. We would've thought it would've gone direct, but both because of the cost of capital, some of the rigidity on terms call protection, other factors that we don't have in our market with the ability to reprice also the fixed rate component in a rising rate environment or
potentially high rate environment, these are mostly floating rate instruments.
(14:53):
We've recaptured some share and it's actually been across sectors, so it's actually been terrific. But I do agree that a well-functioning direct capital market, a credit market in our markets, I think it's just only going to be beneficial to sponsors that they think about ways to finance their deals, ways to recap their deals, ways to think about other ways to monetize capital. And again, like when Larry asks about fundraising and we talk about how there's been this short-term cash squeeze for LPs and how's that going to impact, the thing that obviously makes us so bullish about this asset class is it's attracted a staggering 10.7 trillion of capital in the last decade alone. Still the amount of just dry powder that's sitting on the sidelines, the resilience of this asset class and just the attractiveness of it to so many types of different investors that has not changing.
(15:42):
We may be in this interesting moment here of some liquidity issues and a little bit of a backlog build on portfolio companies, but you asked veto at the outset to look forward, I'm really excited about 2024 and 2025. I don't necessarily think we're going to see another 2021, which on the one hand is not a bad thing. I was exhausted after 2021 as we all were, so I wouldn't mind an actually a little bit more of a normalized return, but there's going to be just a tremendous amount of activity and this asset class is incredibly resilient and I don't think that as major limited partners, pension plans, et cetera, think about where they're going to allocate their capital, that private equity is going to see a downtick. I think to the contrary, it's going to continue to be incredibly attractive place to park capital.
Vito (16:23):
And it's interesting, Harold, I've probably had an uptick in conversations amongst our corporate clients wanting to talk to sponsors about opportunities that they're considering. Maybe it's an investment or a joint venture, which again, something we really haven't talked about in recent years to fund an opportunity that's slightly different than their core business and they're looking for capital and they recognize that there's such a large pool of capital. They also see it as an incredibly intelligent investor base that can get a concept quickly and as a result, they want to see if there's partners out there that they can align with and find more opportunities to work together. I think it's not just a valid avenue
when they're selling one of their divisions that doesn't make sense to the core any longer, and they first look to private equity as a potential buyer, especially folks that are operators, and so they're looking for more opportunities like that, which is encouraging, and I think like you said, they understand that asset class more today than they ever have.
Harold (17:21):
That's so completely accurate. And to an earlier point about the types of transactions we're going to see, you're right, sponsors buying assets from corporate. Sure, we'll see that the traditional carveout, but there is no stigma anymore in the corporate boardroom to finding ways to partner with smart private equity to figure things out. Maybe it's that acquisition you don't necessarily want on balance sheet, but you definitely want it, and so you're doing some kind of a joint venture. Maybe you don't want to consolidate it, so you don't want to be a majority owner. Maybe you want to get some kind of external capital because you're very concerned about your balance sheet. You don't want to lever up too much. Whatever it is, the sponsored corporate realms are completely converging.
Vito (17:57):
Well, I just had a conversation earlier this week with a fortune hundred company who has an acquisition program, and as they're thinking about it going forward, they said, would someone ever sign up to potentially help us make an acquisition today, but also be there as we do more acquisitions down the road, like some consistency in our partner?
Harold (18:18):
It's a dream ask for most sponsors. That'd be a dream ask.
Vito (18:21):
My response was, I have a list and it's just a question of who gets the benefit.
Larry (18:26):
But I do think one cautionary note that there's New Department of Justice and F T C antitrust guidelines and precisely because of the success of sponsors, Harold that you talked about, I think they're a little bit more on the cross hairs of antitrust regulators than they've been. So it's early days as to how that will play out, but it's an important statement of intent on the part of the government that they're going to look at things that can create trends towards less competition, not just an actual situation that has less competition or that leads to less competition, and they're also focused on the labor aspects of transactions. So sponsors and their council and their advisors will be paying attention to that as well.
Harold (19:09):
Two things though, and one I'll ask John to comment on. One is absolute what you said, the roll up strategy mentioning roll up specifically in their guidance, how does that impact reviews? Because it is a pretty powerful thesis that a lot of sponsors have around portfolio companies, building platforms, building bigger and better companies, more efficient companies, and so how does that factor into approvals and antitrust review? But the second thing is it's just been slower, and so we found that commitment lengths that we've been asked to underwrite to support our clients' transactions are getting longer because there's more questions around just delays. It's not just a US thing, right? There's multiple jurisdictions that are impacted by a lot of these deals and they all move at different paces. There's worries of second reviews and so right, John, we've been asked to park our capital with our best clients on these best transactions for longer periods of time, and that's also something interesting. It also pertains to the direct credit market who doesn't necessarily want to reserve that capital for as long as they've had to do?
John (20:10):
Yeah, it's a great question. I always refer to it at the time, decay, a risk of a commitment is what really puts banks on edge because you can make credit decisions, but price decisions are really market dependent, and so to your point, when we go longer than four or five, six months, we try to be smart about building in cushion or building in step-ups and caps and ways to de-risk via escrow and ticking fees, but that's going to put pressure on the cost of capital and the length and the diversity of the bank groups, especially for larger transactions. I think the unintended consequences of some of that
regulation are going to have a speed bump effect on some of that. And you're right, I mean a direct lending solution is no better because they don't want to reserve that capital because it's just not being deployed, so you can't look at that as an avenue per se. You can either use more equity or equity balance sheet, or you can look into ways to de-risk. I think some of the deals that we even saw this summer where there's potential to go to market sooner and use escrow and ticking fees, you'll just see more of that from the community to be able to get to market sooner and bridge that regulatory risk if it does get longer.
Larry (21:21):
Clearly designed to make things more complicated and probably more protracted.
Harold (21:27):
For sure. This is where we've been able at R B C to really distinguish ourselves with our clients, not just relative to direct credit, but also other banks. There's certainly been a lot of reticence with some of our competitors to go along commitments for an extended period of time in light of what happened in the last couple of years where that has been, to your point, John, where troubles kind of arisen because you can only price a commitment at the time price risk at the time that you're signing on the dotted line, but what we've been able to do is take a longer term view of this business. We've got such an incredibly healthy balance sheet and we know that for the most part, working with our clients to get to the right end, right answer, find ways to get to market even earlier, as John pointed out, give 'em the right advice, do transactions, which otherwise wouldn't be able to be financed if you weren't willing to take a little bit of that longer tail risk. I think that's where we've been able to distinguish ourselves, continue to gain share. It's just been tremendous to watch us, the sponsors business, not just in leverage finance, but across m and a and equities rise in the league tables as much as we've done in the last 24 months in spite of everything we've been talking about in terms of deal volumes. So it's been tremendous to be able to partner with everyone here and be able to achieve those outcomes.
John (22:37):
It's all about being consistent, being consistent for clients in all markets, not just when the markets are green and going up, but giving good advice and being deliberate and consistent.
Vito (22:47):
Well and it's cohesively delivering a solution that doesn't favor one product versus the other, and making sure our clients, again, not to be repetitive, fully understand all the alternatives that they have available to them and the fact that we can assist them with all those alternatives.
Harold (23:03):
To your point about the regulatory environment, there's definitely a lot more focus with our client base and their council as they think through the structuring of transactions, the road to syndication, the road to closing, what do they need to actually put into purchase agreements? What do they need to be willing to live with to actually be successful on transactions? It's gotten a lot more complicated and maybe again, on secondary transactions sponsor to sponsor, they're still not as much scrutiny. Those are easier, but as I mentioned before, those have been less prevalent, so I think this is a bigger issue going forward and certainly something that we're going to need the full breadth of our firm and our best
advisors and experts to help our clients think through as we move forward.
Vito (23:48):
A piece of advice that I know we've all been giving to clients in the current time period is that what we're seeing out of the F T C and D O J is that when they came into office a little less than two years ago, they all talked about modernizing the current regulatory rules and making sure that the review was up to date. We've seen it in terms of what they've proposed from a filing requirement on the H S R guidelines. We've seen it now in terms of the merger review requirements, which I think are going to expand beyond just mergers, but also to just any transaction, and we think that with the comment
period that's currently going on, and then the month or two it's going to take to implement any new change, that there's a three or four month window here right now that if you're close on a transaction, it might behoove you to move a bit quicker to get something done sooner and be ahead of those changes and try to get that done because I think the time period and the cost and just the work that's going to be required to get transactions approved and then closed is going to increase noticeably post that time period.
(25:00):
Harold, John, thank you for joining Larry and me today on the podcast. I'm sure this won't be the last time we have you on just given the relevance of your markets to the m and a markets and all the interplay that we have here, so thank you very much for joining us.
Harold (25:14):
It was great To be here. Thanks for having us. Always happy to talk about the financial sponsors business, so really appreciate the time.
Vito (25:20):
Another great conversation, Vito. Thank you. You've been listening to Strategic Alternatives, the R B C M and A podcast. Join us for more analysis about what's moving the m and a markets in our next episode. If you'd like more information on the topics discussed today, please contact us directly or visit rbccmm.com/strategic alternatives. This podcast was recorded on July 27th, 2023. If you're enjoying Strategic Alternatives, don't miss an episode. Subscribe to us on Apple, Spotify, or wherever you listen to your podcasts, and please drop us a review and or comment.
Speaker 5 (26:03):
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