Vito:
Hello and welcome to Strategic Alternatives, the RBC Capital Markets podcast. We're here to uncover new ways to raise capital, drive growth, and create value in an ever-changing world with insights and outlooks from the RBC Capital Markets team. I'm Vito Sperduto, Global Head of Mergers and Acquisitions, and today I'm joined by John Cokinos, Global Head of Leveraged Finance and Capital Markets. John was previously with us in the summer of 2023 talking about the leverage finance markets, so it'll be great to get an update from him. And also we have Hank Johnson, co-head of US mergers and acquisitions. Hank's been my partner for the last 10 years plus and has a very strong perspective in terms of where we are from an M and A market in the US where sell sides are, which is a business that he ran for many years and developed here at RBC into one of the largest franchises on Wall Street.
And so really looking forward to exploring the factors impacting the private equity M and A environment in particular, and what we can expect in 2024. Hank and John, I'm excited to hear your perspectives. Let's dive in. Welcome to the podcast.
John:
Thank you, Vito. Pleasure to be back.
Hank:
Thank you, Vito. I'm excited to spend time today talking about this topic, and as you said, a majority of my time is spent with PE related situations and that has been a strong contributor to the growth of the overall RBC M and A platform.
Vito:
So why don't we start off, Hank, maybe first with you? And you and I always talk about this in terms of where the markets are and what we're seeing from a volume perspective, the deals, we certainly always closely tracking our pipeline, which is an incredible indicator of what we're seeing on the street, but in '23, we saw a decline in global M and A volumes of roughly 17% in terms of announced M and A volume in 2023. A lot of that was driven by a significant drop, roughly 25% to 30%, in financial sponsor related M and A, and we actually saw an uptick in corporate M and A. And it's interesting, a lot of people have quoted it and it's been out there quite a bit, but '23 was the first year in a decade where we didn't cross the $3 trillion threshold in terms of global M and A volume.
Certainly going into the year, we all expect that it'll pickup in the second half, and I think it's pushed out a bit. One of the things we'll talk about, Hank, is just the pent up volume of assets that are waiting to access the market in '24, which hopefully gives us some hope as we look forward. And then in the US M and A market, this past year it was roughly about 44, 45% of global M and A volume at about 1.3 trillion, so a good size level of activity. The US, as opposed to global, was only off about 10% in '23. And I think we're seeing some bright signs in terms of 24 starting to see an uptick. But maybe Hank, as you look at '23 and look into '24 for some forward view, how are you thinking about the financial sponsor or private equity related M and A environment? Maybe talk to us a little bit about some of the trends you've been seeing and hopefully what that gives us as indicators for '24.
Hank:
All right, thanks Vito. You're right. I mean, '23 was a hard year for the private equity to put money to work, right? Private equity is active control investors and we've seen their volumes down over the past two years. If you think historically, private equity represents 30 to 35% of M and A volume in a given year, and they've been well off that over the past 12 to 18 months. And so the positives last year, where were we seeing activity? There was an increase in take private volume and RBC was active with our clients, whether CD and R with Veritiv and CD and R and StonePoint with Focus, Vista with Duck Creek. We also saw an increase in carve-outs and corporate investors. Went from a corporate standpoint looking to optimize their portfolios, those were also transactions that could be done by sponsors. We advised ADT on the sale of their commercial business to GTCR as an example.
And then a third type of transactions that were active last year is the co-control stake sale or a minority sale of an equity state. And we saw this largely on well-performing businesses and looking to preserve a capital structure. We will talk with John about the dynamics in the financing markets, but we advised Bain on its sale of a co-control stake in USLBM to Platinum. We advised Ontario teachers on a stake sale of CQ to Rent House. And so private equity was looking to be active in '23, but what we didn't see was the more traditional sponsor to sponsor transactions.
Vito:
Yeah, certainly Hank. I think the fact that that sponsor bid was not there when sponsors were themselves selling assets has limited it. On top of it, we saw some glimmer of an IPO market, but from an exit perspective, certainly last year saw a drop. It dropped in '22 versus '21, it dropped in '23 again in terms of the number of exits that the private equity firms were able to achieve. And so as you have always talked about, it's kind of tightened up that flywheel as they're thinking about capital going back to their LPs and going into the next fund and so forth.
Maybe as we think about the environment and that deal count, how are you seeing the sponsors think about the assets that they're considering for monetization? Some of the stats you and I have talked about have been that last year, I believe that the average hold period for assets in private equity firms is roughly about 3.3 years on average per PitchBook, and that compares to about two and a half to 2.6 years on average if you go back to the pre pandemic period. And so they're certainly holding them longer, but what are you seeing as a result? How are they starting to think about those transactions and maybe some specific actions that you're taking with clients to assist them in evaluating when to access the markets?
Hank:
I think those are good points and good questions. You hit on the flywheel, which is a key component of what we expect for activity this coming year or in 2024, which is LPs, limited partners, invest in fund eight, for example, because they're expecting the return of capital from fund six or whatever the funds may be, and there has not been the return of capital to limited partners that supports all these funds that have been raised in the record dry powder. So we need to see an increase in exits. And as you note, the whole periods have turned longer, trended longer, and there was a study earlier this year, there's approaching 3 trillion of assets held by private equity, and so it's a very large backlog.
While there's a lot of focus on the dry powder, we really think it's this mountain of exits that need to happen. This can drive more activity. what we've typically seen is that better assets come first. And so we're spending a lot of time with our clients, they're looking for our advice on the timing and optimizing not only value, but certainty. Certainty is a very key point always, but especially right now, no one wants to pull a transaction, and so that is where we're spending a lot of time with our clients right now is just thinking about what's the best way to optimize value and just uncertainty.
Vito:
And maybe John, if we pivot to the leveraged finance markets and what you're seeing there, it's been an interesting trend. We've got a couple of lines going in different directions. Last year I believe was the first year where the average equity and LBOs was above 50%. I think it was 52%. I just saw the statistic. And so if you think about that, there's larger equity checks, larger equity percentages having to go into transactions, and then you also have the amount of leverage on the average LBO coming down where we were seeing in prior years deals that were seven times maybe higher. And John, I think the average leverage last year on LBOs was something like high fives, high 5 8, 5 9 in terms of turns, which, again, puts a lot of compression on the capital structure. But how are you seeing that trending with the client base these days?
John:
That's a great question. I mean, 2022 was a transitional year for leveraged finance and for private equity deployed in M and A and leveraged finance lending. So a few things going on. The Fed was in rate hike mode throughout the course of the year, which created a lot of uncertainty and volatility, a lot of concerns around a recession or a looming recession or the ability to land the economy. And third, the unsecured high yield market, especially the CCC part of the market, has been yielding 14% for the better part of 2022. All three of those made it really challenging to deploy capital in LBOs. And to your point around the equity checks, the only market that was really available was secured, whether it was loans or high yield, and so the balance of that capital had to be made up by equity checks. I think it's like buying a house.
I think sponsors were saying, okay, well get what we can get done today, buy a company that we want at the right price and then look to recapitalize it down the road when the markets are in better shape. But it's important to buy at the right level versus overpaying. That's another thing that we saw last year is that the equity markets were actually very strong and despite the fact that there was less debt available because of higher interest costs, I mean the Fed went from zero rates to five and a quarter in the course of 18 months, which was a massive impact on interest and debt burdens on companies, but that valuations really didn't change very much. So the ability for companies to pay debt and pay interest was significantly limited last year. And if you look at the loan volume, 2021 LBO loan volume was in excess of 140 billion dollars. Last year, it was barely 40 billion. And so you can see a massive dropoff because of that volatility.
Now I will say I haven't felt this good about the leverage finance market since the beginning of 2021. The Fed, for all intents and purposes, looks like it's pausing, the economic data continues to show an economy that is on target for a soft landing, inflation continues to trend lower, and I think we're poised to see the Fed actually start to cut rates. And so I think we're finally seeing the green shoots that we needed for the ingredients for M and A and LBO activity to pick up. And if you look at last year, we did see a few fits and starts. I mean, in August, we underwrote a few LBOs, as Hank mentioned, we did the Vertiv LBO for CD and R, we were also in the [inaudible 00:12:17] LBO for Elliot, and then the Simon and Schuster LBO for KKR. And at that time, we thought there was a little bit of a resurgence in the market. Things looked like they were calming down on the inflation front, and then we saw a little bit of a hike and spike and things in September, which led things to kind of calm down again.
But then coming out of Thanksgiving this year, I think we started to see another round of green shoots, which have led to where we are right now. We're starting in the first two weeks of January. I mean, there were 30 billion dollars of repricing alone announced this week in the marketplace. The high yield marketplace has also opened up, but what we're not seeing is activity yet. I mean, we underwrote the rocket software purchase of the OpenText assets back in November. We've got the Ahead financing in the VAR space, which is a small tack on. But a theme that we did see a lot last year, which I think will continue, is that sponsors adding to their Portcos via M and A as opposed to de novo LBOs until they think the cost of capital has improved, but I think we're primed for that cost of capital to improve this year and to see the unsecured market open up in high yield.
Vito:
Yeah, it's interesting, John, for you to talk about some of the volume coming from re-pricings. On the corporate or larger cap side, seeing an environment where if I believe if I have this correct, today, the average S and P 500 balance sheet has about two and a half turns or so of leverage debt to EBITDA on their books, and that compares to about one and a half turns pre the global financial crisis. But the difference also is that their cash balances are much, much higher, significantly higher than pre global financial crisis. And so in that world, we're seeing large corporates build up cash and holding that cash to pay down leverage when it comes due, when it matures and not necessarily putting it to work right now. And so they've been hoarding a fair bit and they have financed at incredibly low rates.
I mean, how are you seeing it in terms of some of the private equity backed companies today? It sounds like they've got some financings on their books that are fairly attractive levels. It's probably very difficult in terms of doing new financings and having to reset rates to today's levels versus what they were able to achieve even two years ago.
John:
Yeah, that's right. And I mean that's the beauty of the loan product is the ability to be repriced after the soft call rolls off. I mean, if you look at the deals that have been brought to market this week, especially the ones we're leading, Hank mentioned the focus financial LBO that we completed in the summer, but we're now already repricing the focus financial capital. So the financing that they executed in July was a SFR 350 term loan, and now we're repricing that term loan down to 275, which is actually going to be one of the biggest spread compressions that's been done since the market reopened this year. But you're seeing a lot of that play out. And we're also looking at the deals that were just done in the fall and getting ahead of the repricing that we can start to do that monetization and kind of rightsize these capital structures. So I think that and dividend deals are going to be prevalent as sponsors bought businesses as best they could.
And now if the markets are getting more favorable, there's going to be more depth for leverage, cost of capital is going to come down that they're going to recapitalize these businesses with re-pricings as well as dividends going forward.
Vito:
Hey Hank, maybe let's touch upon that incredible volume of assets waiting to pursue exits, that over 3 trillion that you mentioned earlier. I think John's highlighted the importance of the financing markets and where we're expecting interest rates. By the way, shout out to our US chief economist, Michael Reed, who was probably the first out there to talk about interest rate cuts starting in the middle of '24, and this was several months ago, and he was expecting 125 basis points of cut in 24, which is where the market has basically coalesced to right now, and he seems to be on the mark there in terms of when rate cuts are going to start. And I think yes, our clients are feeling better about where interest rates are and likely that maybe it's higher for longer, but it's at these levels and then it's going to come down eventually.
But Hank, maybe address the all important valuation gap. Do you think buyers and sellers have both come to some meeting of the minds in terms of where valuations are in today's market? Have sellers come to a point where they're more focused on that certainty and doing a deal at the right price but not necessarily the highest price versus are buyers ready to pay some of the prices? Because we're certainly seeing corporates take advantage of that, but maybe talk about that aspect of bringing buyers and sellers together as a driver and how important that is relative to the financing markets.
Hank:
I think that's a very good question and it is definitely an issue over the past year, and I think that dynamic of bridging valuation gaps is one of the reasons why there were more take privates where there is a public marker of value out there versus a private seller who made the initial acquisition at a higher value and wants to hold. I think that as John talks about the improving financing environment, there is just a pure math aspect of the cost and the cash flows and the ability for buyers to pay more, and I also think the passage of time and the performance given, as John said, the soft landing, improved inflation trends, the labor dynamics, companies are performing, in many cases, better than they had expected at the beginning of '23. And so therefore, I do think that sellers are getting more comfortable in this environment. That valuation gap is being bridged through the availability of incremental capital, sellers understanding the market.
It also ties back to we expect that better assets will come to market first, which better assets preserve some of the higher multiples from a seller standpoint, and so we see a number of positives that will help bridge these gaps and lead to increased activity.
Vito:
Hank and John, as we wrap up this portion of our discussion today, I do think a lot of people are very interested in when do we see traditional sell sides or LBOs sort of broader processes coming back to the market. What are you looking for? And then more importantly, what are you hearing our clients say in terms of what indicators they want to see? How do they adjust to this environment and get to the point where we're doing more traditional deals? Versus Hank, for example, some of the transactions where we've done continuation funds or minority sales or things like that. What are you hearing clients talk about,
Hank:
I think that for a lot of the traditional private equity investments and where you have a steady cashflow and there's growth, they're looking for certainty of financing. And John's talked about the strength of the secured market, but I think people are looking for an unsecured subordinated to replicate some of the existing financing structures. Now, it may not be, as noted earlier, what was six and a half times leveraged before may be six or five and a half times just because of the cost of debt, but we want to make sure that the... Sellers want to know that there is a financing structure available to support their value expectations. So I think that is a key piece is just understanding the financing certainty in the market. And John, I think you agree around the thought around subordinated debt and unsecured?
John:
I do. I do. I think that's been one of the key ingredients that's been missing for the last year, and that's a result of just cost of capital. We did what we could do in the environment, which was maximize senior secured debt in capital structures and using a combination of secured notes and term loans. In a high value technology software situation, could you push that into the sixes? Yes. But with an industrial, you're kind of in the low fives, sometimes in the mid fours, and so you're missing that junior part of capital. And as we look at where the markets are right now, if you look at our broad high yield index yesterday, it closed at roughly 7.5%. I mean, that's the best it's been in 12 months. If you look at the triple C index... And again, the triple C index has some, no pun intended, some junk in it, so we also have an unadjusted index, but the overall index is at 12 and three quarters percent. The adjusted index is closer to 12%.
That puts you kind of in the low single B range is probably in that nine and a half to 10.5 percent range, which, again, on a historical basis, LBOs, for the last 20 years, sans the zero rate environment we're in, you place secure debt in the seven to 8% range in the junior debt, 400 basis points behind it. That worked for LBO returns to get to an IRR in the high teens to low twenties. It's just the zero rate environment we were in out of covid, I think people are looking for that to be replicated, and that's probably a world that doesn't exist absent a crisis again. But when the Fed is done and it starts to lower rates in a neutral stance, that means short-term interest rates are 3.5%, so that means SFRs at three, 3 and a half percent versus five and a quarter percent today, so that's a reduction in the base rate, but put secure debt again back that seven to eight and a half percent range and then the unsecured behind it.
So that will allow the ability to put some more leverage on incrementally, but it takes a zero rate environment for us to have that max leverage of seven and a half plus times because the debt burdens are just going to be higher and the cash flows are less robust. But we are certainly poised to see that return. I actually think the markets may be ahead of where M and A processes are, Hank, and where company's heads are because valuations are still pretty sticky.
Hank:
I think that's right. And I think what you said also supports the better assets coming because you need high free cashflow and or high growth to drive equity value. And to your point on the markets returning ahead, there is some lead time for a sell side process. You have to do the prep. Here we are turning the page on a new year, you have to have the financials updated. So I think a lot of our clients, back to Vito's question of when, were talking about that, and I think increasingly, there are clients who are prepared to approach the market knowing that they could be a little uncomfortable because when the market opens, you want to be early. You're going to have to be comfortable being a little uncomfortable, and I think that's a conversation we're having with a lot of parties right now.
Vito:
Hank, you made some excellent points, but I would highlight those last two, the fact that you need to be comfortable being uncomfortable and that we do believe that it is important to be on the earlier end of the window when it does open up. Certainly if we look back to a year ago, there was a lot of expectation that we were facing a recession in the economy. Now the view's coalescing around a soft landing. That's probably more top of mind for the CEOs and operators versus the partners at the private equity firms in terms as they're making decisions. But we've talked about the fact that they love the assets that they have, in many cases, they're trying to figure out ways to potentially extend their life, but at the same time, the folks that are controlling the investment committees are looking at these assets and saying, "You know what? We're doing well, we should monetize sooner." And so I think it'll be an interesting push and pull to watch as we go into '24 where, certainly, I think the general view is that we're going to see an uptick from '23. I think it'll be interesting to watch that as we look forward.