Sponsors can operate in high-rates environments - Transcript

Vito (00:06):

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 Vito Sto, 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. Hi Larry. Great to be here, Vito. And today we have some special guests from some of our product teams. We have John Conos, who's the global head of Leverage Finance and Capital Markets here at R B C. Welcome John. Thank you Vito. Thank you Larry. Pleasure to join you today. And also we have Harold Vera who co-heads our global financial sponsors coverage. Welcome Harold.

Harold (00:44):

Thanks for having me.

Vito (00:45):

So I thought today we'd look at how the trends that are happening between the financial sponsors and in terms of financing transactions, how they're impacting the m and a markets. I think we've all talked about expectations for 23 as we've been going through the year and even last year as we were coming into 23. And we always thought that it would be a market that in some ways would be similar to what happened last year, but inverted. So we expected that the strength we saw in the first half of 22 and then the decrease in the second half of 22, we'd see inverted this year. We've certainly seen it play out in the first half of the year with volumes shrinking significantly across m and a and also across the private equity world. And we're starting to see some green shoots, which we'll talk about in terms of some transactions that are getting done and I think it'll be pretty interesting to understand how deals have evolved, how our clients and how our teams are getting transactions done in this environment, whether it's an interim period or whether it's a new normal, but a lot of the same conditions we've always seen in terms of the depth of the dry powder that they have, the fact that they seem to be a leading indicator for a lot of transactions all are there.

(02:07):

Let's start with you, Harold. Would love to understand a bit, given where we are today, put it in perspective over the last six or 12 months, what are you seeing from your clients? Where are you seeing the focus? How has it shifted?

Harold (02:21):

Well, sure, Vito, and I think your introduction is spot on. We entered this year pretty measured. We're going to compare a lot to 2021, but we have to kind of take a step back to your point and realize that 2021 was likely an aberration in our careers as there's just a tremendous amount of pull forward and also catch up resulting from Covid and that shutdown in terms of m and a transactions, monetizations equity deployment, and at the time fundraising was incredibly robust. We came into this year expecting there to be, as you pointed out, a little bit more of the same from the second half of 22. And that's played out. Give you a little bit of context and again we're going to compare it to 20, but that's fine. Recognizing that that was a little bit of an aberration, but deals are down about half from a quarterly peak that we reached in the fourth quarter of 21.

(03:08):

We've seen declines in deal making from sponsors in for the last six quarters. We're kind of getting to a deal count that's in and around what we saw pre covid, but volumes are welled down and we'll talk a little bit about that today, which is the size of many of the transactions that sponsors are consummating is much less than and lower than it was at the peak in 21. A lot of that has to do with the fact that they're adding on to existing portfolio companies. And so as you think about where we've been for the last 12 months now, we've kind of been a little bit stuck. I think the market is trying to kind of figure out where we're heading. So at the end of the day, macroeconomic conditions are the most important determinant of private equity, being able to reach meetings in the minds and having that conviction level to deploy capital. It's also true for corporates and I think we're finally getting there, but there's been a number of headwinds and not just on the macro side and interest rate side, but also very much in terms of their ability sponsor's ability to return capital to their LPs and therefore have that dry powder to be able to raise larger funds and go after deals.

Vito (04:11):

And look, I think when we look at the market right now, the last four quarters from the second quarter this year, backwards four quarters, from a volume perspective, it's the lowest we've seen since mid 2020 and that was impacted by covid. Now as we look forward, we still believe as we said at the beginning of the year, that this year could be flat to up 10% from a volume perspective globally in terms of announced deals. And I think that doesn't take a lot in the second half of this year just given what we're comparing to last year. So there is an opportunity here and I think it's not as bad as people are making it out to be, but again, I think we're finding pockets in our market. That makes some sense. John, from your perspective, what are you seeing in terms of the overall leverage finance market but maybe more specific to the sponsor community in terms of what types of transactions are getting done, where are you seeing the positives? And certainly I think from our perspective as an institution, we are supporting our clients, so that's been an incredible positive in the market. Certainly not to the levels historically, but it is a safe haven in some respects.

John (05:22):

Taking a step back, we're at a place where rates are at a 22 year high. I think the shock and awe of the Fed hikes over the last 18 months coupled with the global macro backdrop of the Ukraine, Russian crisis and China really have been a journey for the markets that we're starting to I think get at the end of, I think we're getting to a place of stability where we're resetting and hopefully we'll be able to see a better flow of activity. We've tried to be very consistent throughout the last 18 months with our clients and I think we have shown creativity. I think of the Emerson Copeland deal is a great example where in October when Blackstone came to us for that financing, it was as bleak as it could be for the capital markets and they had secured themselves a really unique opportunity.

(06:11):

And you don't want to say no, you want to find a way to say yes for clients like that. And I think we came up with a unique structure that used the bank's balance sheet to your point, to bridge them into a better market that we thought would get better and ultimately did become better and lead to a successful transaction for them. But as we look at the market activity right now, I think we are seeing green shoots. We are as busy as we've been from a leveraged finance perspective, underwriting deals. So it's not just the safe havens we were looking at at year end, we're seeing industrial deals, we're seeing consumer deals, we're seeing healthcare deals, we're seeing energy deals. It's not just with tech or FinTech or things that are much more predictable and stable in a volatile environment. We are seeing that the markets are broadening, which think is a good sign of where things are to come.

(06:57):

Now what's changed is we are in a higher rate environment. We went from zero rates 18 months ago to 5.5% fed funds rates right now. And so that has changed the cost of capital dramatically. And so whereas two years ago we were looking to maximize leverage on transactions. Now we're trying to optimize capital structures because the interest burdens have changed so much. And so underwriting has gone from max leverage to solving for a B two outcome, which means less leverage, stronger cashflow coverage, more equity unfortunately. But valuations have not really tipped yet. We're seeing valuations starting to come the way of our buyers, but I think that's the last shoe that will drop because the markets are going to be at this level for a period of time. The Fed hasn't said how long they're going to be here, but I think we are now at a point where the markets are going to underwrite and now valuations now need to calibrate.

Larry (07:49):

John, I want to follow up on that because I think it drives a lot of things not just in deal activity and sponsor deal activity, but also overall economic activity. We had 15 years of 0% interest rates effectively, and now we've reset as you say, and it seems as if we're going to be at elevated more and less in today's interest rate range for some time. But if you look historically we've had very healthy deal markets over the decades with interest rates at levels comparable to where they are now. So I think one question for you is when you look at the interrelationship between interest rates and perhaps staying where they are for some time on the one hand and macroeconomic conditions on the other, are you encouraged by the fact that even at these levels of interest rate and even with some obvious concern about economic growth, that we're still seeing this type of activity and do you think we can have a generally healthy deal market if the cost of capital stays much higher than it was the last 15 years?

John (08:50):

I do. I think you're right. Historically, the high yield market average yield is 9%. We got as low as four point a 5% coming out of Covid, which really called into question the name of the high yield market. It was really a low yield market, but historically that's been a cost of capital that has worked for private equity and corporates. It's just the recalibration of expectations. And on the floating rate side, L I B O R or now, SFR has tended to be in the three to 4% range. And if you think about where fed funds rates will go once we've stabilized, they're not going to cut to zero unless there's a crisis for them to do it, but they're going to get to the real rate of return, so that gets to three to 4%. That's still going to be a place where deal formation can occur.

(09:30):

When you're at this reset or a new cycle beginning, you see the higher quality companies come first to the deal market. So whether it's an Emerson that we financed last year, which was a very solid company, some of the things we're looking at now are situations where corporate has made a decision to divest an asset and it's indetermined of the markets. And so that asset is going to be a pretty pristine asset that the markets will look at or if it's m and a activity or sponsor activity, they're willing to buy and put more equity in play because it's something they really want as opposed to buying something because they have to deploy.

Harold (10:02):

Sponsors can operate within this environment, they can operate in higher rates environments, they've operated within higher rates environment in the past and they've been able to be very successful. It's an incredibly resilient asset classes as you know, and funds deployed during periods of whether it's more vulnerable economic situations or even recessions have typically outperformed funds deployed during bull markets. And so it's more of the uncertainties we talked about. That's been the death kn of deals and what John was alluding to where it was just kind of rapid rising at interest rates and no end in sight. I think now we feel like those clouds are lifting and I think sponsors can operate and deploy capital with confidence and also be able to exit assets at valuation levels that they feel are, they're not going to look back and say, wow, was that a mistake? Whether you're a buyer or seller. And so I think John's absolutely spot on that we're kind of getting to a point now where we may be in this higher rate environment for some time, but that doesn't mean that we won't see actually a pretty remarkable uptick in transaction volume.

Vito (11:00):

Maybe Harold, talk a little bit about how you've seen your clients adapt or approach to evaluating transactions. We always talk about the sort of difference between how the investment committees look at something versus the partners that are bringing the transactions forward. And obviously in different cycles we've seen the investment committees reset the parameters that they require from a return perspective, minimum equity rates, assumption growth assumptions and the like.

Harold (11:27):

Yeah, another incredibly creative bunch and they're going to have to continue to be creative, especially in this environment as they think about ways not only to deploy capital but to monetize existing investments. And I'll tell you what I've really seen is two things. One, I've seen sponsors make sure that the transactions that they're doing is absolutely in line with who they define themselves to, their limited partners. They do not want to do deals that are outside how they have gone to market with their investors. And so they're very focused on saying, this is our type of transaction, this is a vintage deal that we do at our firm. And so they've been very focused on that as opposed to we're going to wade into some new sector or we're going to do a carve out when we've never done a carve out or what have you.

(12:10):

The other thing I've seen, and this is really not a surprise and it goes to the valuation point John was making we should talk about it, is there's been a tremendous uptick in take privates. There was a time where with valuations in the public markets, there was just nothing available. And there's been 43 take privates that were done in the first half of this year that's the same as done in the first half of 22, 22 ended up being the highest count for take privates in the last 15 years. And again, that shouldn't surprise anyone just given where valuations were. What is surprising is that 23 of the 43 this year or below a billion dollars in transaction value. And so that tells me that the sponsors have kind of started with those, what we call orphaned smaller micro cap public companies where liquidity float just way too low, no real site for tremendous increase in value.

(12:59):

And so they've been going first. Now the question of course will be, and this goes to the valuation point, when will we start to see those larger take privates happen, those with still substantial sponsor overhang, they don't want to sell in the secondary markets, take a big discount other corporates who the 52 week high is well in the rear view mirror now. So the boardroom's a little bit anxious. My gut tells me this trend's going to continue and we should continue to see a tremendous amount of take privates and to John's put with the leveraged finance market, it's going to support those types of higher quality assets.

Vito (13:28):

It's interesting, I was looking at a statistic the other day in terms of the percent equity in financial sponsor transactions and typically over the last 10 years, about 44% of the capitalization has been equity in the deals that they've done over the last four years. It's ticked up, it's been about 46 to 47%, which by an annual basis is a high relative to that 10 year period. The first two quarters of this year is actually popped significantly. Now it's just two quarters and I think because of multiples and because of capital debt financing availability, it's 57% for the average sponsor deal. So almost 10 points higher and certainly that's going to come back down. But it's something we talked about Harold, where they're over equitizing transactions, they're taking on less of the leverage at these higher rates, but reality is it's what's available from a financing. 

Harold (14:19):

Perspective. And I think what you're really getting to is the availability of junior capital and a lot of these deals, but because of the quality of the assets, even if valuations have somewhat ticked down, there's a couple examples this year, right John, like Qualtrics where it didn't really matter how much debt was available that was just trading at such a big multiple that there was going to be a tremendous amount of equity in that and that probably skews those statistics you're referencing. But in those sectors, those higher multiple sectors, valuations haven't reset that much on a revenue multiple. It's been average about 2.2 times for the last four years. We're now at times, so there's been a slight downtick, but sectors like tech sectors like healthcare, they're still commanding tremendous multiples. And as John will tell you, if you don't have that availability to max that leverage with the junior piece of the capital structure definitionally, you're over equitizing them.

John (15:07):

You raise a couple of good points, Harold. I think if you look at the flow of capital right now in the markets we're starting to see stabilization. There is two different technicals. The high yield market I think is in a much better shape right now and I think we'll continue to be in better shape, which I think will lead to more junior capital being available. I think six months ago. With the rising rate environment, it's very hard for portfolio managers to get comfortable deploying long-term capital with duration risk. But now if we're at this plateau or maybe one or two hikes left, it's a lot easier. I think in the loan market we have a little bit of a different technical which is related to CLOs. There's a cadre of CLOs that are maturing and hitting their what's called their reset windows where they cannot refinance or take on new assets.

(15:48):

And so when you look at taking on risk and portfolio managers are very worried about the B three category right now and looking back at the last three years of deals where deals were over levered relative to we're now they're worried about performance and portfolio issues. So for the C L O market to really get back into gear, we need to see new C L O formation which will happen as liabilities stabilize, as rates stabilize. So to your point, I think the markets will follow and develop and grow and support larger transactions and we'll see the market be receptive to larger deals as these levels of capital start to find some stability.

Larry (16:22):

And I'm glad, Harold, that you raised the take private point because conventional wisdom is often, well if rates are going up especially so rapidly and especially with such a big departure from the prior several years, then how can take privates which depend on debt actually go up? But it's interesting that people move very quickly. It shows the market's quite efficient in this to look for pockets of opportunity even in a very difficult overall equity market environment which we had coming into 2023 and now the confidence in the equity markets helps both regarding exits for sponsors and also for just people feeling comfortable that even if they over equitize a deal coming in at this moment, that there will be opportunities to recapitalize over time as confidence gets stronger in the economy at large.

Harold (17:11):

Yeah, that's a terrific segue Larry into what we also need to talk about, which is if you talk about take privacy, you have to talk about IPOs and of course they're incredibly relevant to deal making because it's just such an important means by which sponsors can monetize especially their larger assets and it simply hasn't been open to them in the last 12 plus months. If you think about the last couple years, I think we've had 22 IPOs in 22 and 23 year to date. Just to give you some context that compares to 202 in 2021 from account perspective. And I mean the good news is at least many of the ones that have come this year and there haven't been many have performed well, but if you look, overall monetizations of existing assets by sponsors is down almost two thirds from a quarterly peak of 2021.

(17:58):

Sponsors need a functioning i P O market, especially as an option whether they even choose to sell it or not, whether they choose to sell that asset, take it public, they need a functioning i P O market, especially for their largest assets to be able to at a good pace monetize those businesses. And what we've seen is it hasn't been there and so the exit backlog is growing and growing rapidly and that's going to cause a little bit of a stalling in the redeployment of funds until they can actually monetize existing assets and return capital back to their LPs and be in a position they can redeploy.

John (18:29):

And don't you think, Harold, now talking to Vito and your team in m and a, that backlog could be what facilitates the valuation change? Because if people have a need to monetize in their fundraising cycle with their LPs that they may need to capitulate on price to be able to show a print which could lead to more deal formation.

Vito (18:47):

Yeah, John, that's a perfect comment. I think in prior years when we've seen fundraising cycles, sometimes they're selling stronger assets to put a bigger return up on the board to encourage that redeployment capital into the next fund. Now, I think there are more of a scarcity of exit opportunities and I think they're going to be looking to see where there are more potential monetizations that can happen in a quicker timeframe so that they're returning the capital and again, improving the fundraising cycle.

Harold (19:18):

These funds are not infinite. It's a pretty attractive business model for the equity because they can be patient and sponsors have been patient because they've obviously entered in a lot of cases at higher multiples than traditional levels, and so they have been patient because no one wants to monetize something at a return that's not attractive. And so the model does allow for some patients but not for infinite patients. And so you're absolutely right, John, at some point we're going to see a reset in valuations and an expectation that maybe they'll be the first ones to go dip their toes into the I P O market. And again, if you talk about green shoots, look at the July that we've had with the Dow. Look at NASDAQ being up about 35% year to date. Obviously there's been a lot of strength there. At some point, the I P O asset class will need to join that party, and I believe that sponsors are going to probably be willing to take a little bit of discount, maybe even sell a little bit of extra equity in first blush so they don't have the liquidity overhang issues that they have from the I P O class of 2021.

(20:10):

And I do think that if you look at even multiples today, and again, a lot of these are add-ons, but what was an average of 11 and a half to 12.4 times on an EBITDA multiple for the last four years, we're looking at 10 and a half times year to date on average, and again, it's a number that's just pulled out of the air in a little bit because of different sectors and different types of deals, but it's a reset.

Larry (20:30):

Let's just explain for the listeners this issue of equity overhang because when a sponsor owns a hundred percent of an asset and take something public, even in a good I P O market, it's very hard to sell more than a partial stake, which means that on the one hand, you have an to make sure it's a good public company because you need to sell more over time, but it also means from the perspective of the sponsor itself that it's only really a partial exit, and we contrast that often in a dual track to just a straight sale of the entire company and the pros and cons of doing that,

Harold (21:04):

It's actually just really playing out, and that's why I think you're going to see more sponsor backed public companies going private maybe by the same sponsor. It took 'em public and especially because the I P O class of 20 and 21 at very high valuations. To your point, Larry, they sold very small stakes, sometimes a necessity because they needed tole and so there was, most of the issuance was primary just paying down debt so they could have the right capital structure to be a well traded public company, some just simply because the cost of equity capital at I P O is the most expensive because of discounts. I've been talking to a number of my clients on the E C M side, and there is a growing thesis that while we're not probably going to get to what Europe does, European IPOs, they sell a much higher percentage of their stake at I P O.

(21:50):

We may be moving in that direction because the one lesson that's certainly been learned is that while it may be the most expensive cost of capital, there's nothing worse than being stuck where your stock is traded down, it's below I p o price or hovering around it, and you have this vicious loop of, well, if there was more liquidity in the stock, it would trade better. Well, you have to sell more stock then. Well, I don't want to sell stock at a discount to where it is today, and so there's this stalling of follow on issuance because the sponsor just doesn't want to bite the bullet and take that hit, but then the markets won't trade the stock well because there's not enough float.

John (22:23):

Yeah. Well, the focus financial L B O we did is an example of that company went public a few years ago, sponsors one got out, one didn't, and they looked at, it was not a micro cap, but it was a small cap at that point in time, and the next best thing to do is just take it private again and live with it in the private market.

Vito (22:37):

Something you're highlighting is that for our clients, whether they're corporates or sponsors, when you eliminate a number of alternatives that they have accessible, certainly it creates a situation where the valuation all of a sudden becomes more readily acceptable and they have to consider a smaller group of alternatives.

John (22:57):

Think about the rado deal we did.

Vito (22:59):

Correct, and that transaction, I mean, certainly we saw a number of issues play out, but in a difficult market, I think the buyer there, stone Peak had a very strong move by doing a transaction where they made an all equity commitment and took the risk from a debt financing perspective to themselves because they saw significant opportunity with the company. They also saw a transaction that was unique for them in terms of a potential slight expansion of their definition of infrastructure that they wanted to execute on, and they had a very strong thesis and they believed in it. There's examples like that where I think buyers are finding ways to get deals done, especially in an environment if they have a strong thesis and they feel that there's less competition as a result and they're trying to move quickly, and so they're trying to take advantage of those opportunities.

(23:53):

If you're a seller, I think you're more willing to accept certainty and speed in this market versus price. The three elements that we always talk about in any m and a transaction, Larry, and so we're seeing transactions get done. I do think all four of us feel from the conversation here, and we'll talk about it in the next episode, that there is a constructive market and that we feel that we're heading into what could be, especially given a built up pipeline of demand, both from a sell and buy perspective and capital availability, there's going to be a good constructive market. The question's going to be, and we'll get into it whether it's the second half of this year or 24 when it really materializes. So thank you very much for the conversation in terms of where we are today, and we'll continue in our next segment in terms of discussing what our outlook is going forward. Larry, John, Harold, thank you very much. Thank you.
 
Speaker 5 (24:49):

Thank you, Vito. Good Discussion. Thanks.

Vito (24:56):

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 rbc cmm.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 (25:31):

This content is based on information available at the time it was recorded and is for informational purposes only. It is not an offer to buy or sell or a solicitation and no recommendations are implied. It is outside the scope of this communication to consider whether it is suitable for you and your financial objectives. For disclosures, please visit www.rccm.com/disclosure.