Debt & Equity Deal Terms in the Middle Market, Winter 2011/2012

Thursday, November 17, 2011

DEBT & EQUITY DEAL TERMS IN THE MIDDLE MARKET, WINTER 2011/2012

By Keith H. Berk, Kristin L. Dunlap and Ati P. Khatri

BUSINESS LOANS

Although the past two quarters were dominated by news stories involving economic debt crises both here in the United States and abroad, for those who can get credit, the cost of credit in the United States remains very low. In fact, there has been a noticeable decrease in pricing within the middle market, prompted primarily by middle market borrowers price shopping. Well positioned senior lenders have taken advantage of the current lending climate to grow their outstanding loans by offering decreased pricing to borrowers with good credit and strong collateral. Middle market borrowers are showing a new willingness to leave their current lenders in search of the "best deal". In the coming quarters, we anticipate this competition to continue.

While competition in the mezzanine debt market has not increased at the same pace as in the senior debt market, middle market borrowers have far more mezzanine debt options today than they did just two years ago. The optimism felt by middle market borrowers is compounded by an increase in staffing and capital raising by mezzanine lenders throughout the past two quarters.

Private equity players continue to have significant amounts of available capital to invest and have begun doing so by taking advantage of investment opportunities requiring disproportionately high amounts of equity but at discounted values. While much of this activity has been focused on companies at the higher end of the middle market, it may be just a matter of time before increased private equity activity reaches the heart of the middle market.

Based on an informal survey of senior lenders, mezzanine lenders and private equity firms, the following is a summary of deal terms in today's market for financially strong middle market privately held businesses:

Senior Debt

Leverage Ratio:	Loan amounts for well capitalized companies are, in some instances, starting to exceed 2.0 to 3.0 times trailing 12-months EBITDA for companies with less than $15 million EBITDA (there is a noticeable increase since 2010 for loans in excess of 3.0 times trailing 12-months EBITDA). Loan amount not to exceed 3.0 to 4.0 times trailing 12-months EBITDA for companies with more than $15 million EBITDA (with little change from 2010).
Interest Rates:	30-day LIBOR plus 2.0% to 3.00%, or Prime Rate plus 0.25% to 1.00%, for revolving debt with full collateral coverage (with more banks competing for good quality borrowers and offering slightly lower rates within this range); 30-day LIBOR plus 1.75% to 2.50%, or Prime Rate plus 0.25% to 1.00% for 3-5 year term debt (with more banks competing for good quality borrowers and offering slightly lower rates within this range);
	There are still a few banks, particularly at the lowest end of the middle market, that have interest rate floors of approximately 4.0%, depending on whether multiple bank products are being used, the amount of cash deposits and the amount of collateral. Interest rate floors have become the exception.
Advance Rate:	80% to 85% of Accounts Receivable (slight increase from previous quarters);
	60% to 80% of Inventory (fairly consistent with 2010), based on either a forced liquidation valuation or net orderly liquidation valuation (net orderly liquidation valuation is significantly higher than forced liquidation value and has now returned as the more typical benchmark). The advance rate on Inventory is often lower for companies with less than $15 million EBITDA, in part because senior lenders choose not to incur the expense of a third party Inventory appraisal.
Fees:	0.25% to 1.0% of loan amount (consistent with past practices); Unused line fee of 0.125% to .50% for revolving debt with a term greater than 364 days(consistent with past practices), although many senior lenders are using 0.25% as their benchmark. Bank service fees and covenant waiver fees remain historically high.

Pre-September 2008, it was common place for senior lenders to provide financing in excess of collateral value (otherwise known as "cash flow loans"). In 2009, cash flow loans became the exception and were usually supported by personal guaranties from one or more stakeholders with substantial net worth. Throughout 2010, cash flow loans began to reappear for borrowers with very good credit, although interest rates for such cash flow loans were typically at the higher end of the LIBOR rates stated above. Recently, senior lenders have become slightly more aggressive with cash flow loans, at least with respect to companies with more than $15 million EBITDA, but still far less aggressive than pre-2008.

Mezzanine Debt

Leverage Ratio:	Loan amount not to exceed 1.0 to 2.0 times trailing 12-months EBITDA (consistent with 2010).
Interest Rate:	14% to 16%, with 11% to 13% current pay and 2% to 4% paid in kind, for companies with less than $15 million EBITDA (consistent with 2010); and 13% to 15%, with 11% to 13% current pay and 1% to 3% paid in kind, for companies with more than $15 million EBITDA (consistent with 2010)
Fees:	1.0% to 3.0% of loan amount (up from 1.0% to 2.0% in 2009).
Warrants:	Warrant coverage to provide mezzanine lender with an all-in IRR of 16% to 24% (slightly lower than 2009 and early 2010).

Equity Financing

IRR:	20% to 30% IRR (consistent with past practices).
Valuation:	4 to 7 times trailing 12-months EBITDA, with signification variation based on industry and growth trajectory of the company.
Debt to Equity Ratio:	35-50% equity/50-65% debt (up from historic lows of 20% equity/80% debt pre-2008, but down from 50% or more of equity in 2008/2009).
Debt for Closing:	Due to the still tight credit markets, it is more challenging for private equity firms to fund transactions, and many transactions continue to be funded with significant amounts of equity. Many private equity firms continue to require sellers to finance a portion of the purchase price.

Overall, private equity firms are well positioned with large amounts of available capital. 2011 has seen an increase in private equity activity, particularly within the higher end of the middle market. Indications are that this activity should become more robust in the general middle market in 2012.

Real Estate Loans

Similar to the commercial business lending markets, the commercial real estate lending markets are reacting to the global economic crisis and some of the stabilizing factors that we saw in the first few quarters of 2011 are starting to lag. Although banks have begun to loosen commercial real estate lending standards and commercial mortgage-backed securities issuance is on pace to quadruple last year's dollar volume, the second half of this year has seen a rise in AAA commercial mortgage-backed securities risk premiums of 85% since July. Even with some uncertain trends, the multi-family rental market is showing record lease rates and sales prices for rental buildings.

Based on an informal survey of retail and multi-family real estate lenders and brokers, the following is a summary of deal terms in today's market for real estate investors:

Shopping Centers/Retail

Senior Debt:

Typical deals from life insurance company lenders consist of 60% to 75% LTV, non-recourse loans at rates of 4.5% to 5.0%. These loans carry a 10-year term and are typically amortized over 25 years. Loan amounts exceeding 75% of value remain rare.

Conduit lenders have been favoring deals consisting of 75% LTV at rates of 5% to 5.5%. These loans are non-recourse and typically have 10-year terms, amortized over 30 years.

Typical costs include fees of .50% to 1.00% of loan amounts and deposits up to 2% of loan amounts (partially refundable at closing). Lenders continue to focus on strong national tenants with long term leases in place.

Mezzanine Loans:

Mezzanine shopping center lenders are focusing on the greater than $5 million market and remain willing to lend up to 80% LTV, with rates at 9% to 11%. The term of the loan is typically coterminous with the senior debt.

Equity:

Equity dollars for shopping center/retail deals are pricing at approximately an 8-10% preferred return with splits thereafter at 20-50% to the promoter and the balance to the investor group.

There has been an increase in activity (and lending) in single-tenant commercial retail properties, focusing on national, long-term, high credit quality lease tenants, and the medical submarket. Lenders are favorably underwriting these industries and showing confidence in their continued growth by lending on properties with such tenants.

While commercial real estate investors may continue to face financing challenges, they should remain cognizant of alternative lending sources. One such example is the U.S. Small Business Administration 504 Debt Refinance Program. The Small Business Jobs Act of 2010 temporarily extended the 504 program (and its $15 billion lending pool) to allow for refinancing without business expansion. For small businesses facing liquidity issues and having a mortgage maturing before the end of 2012, the 504 program allows the SBA to take a second position loan and contribute up to 40% of the fair market value of the underlying assets, thus working around many lenders' LTV ceilings. Alternative financing vehicles like this may provide investors a bridge until permanent growth in the general economy is achieved.

Multi-Family Residential

Senior Mortgages:

Life insurance companies are lending at 70-75% LTV over a 10-year term with rates at 5-6%. These are non-recourse loans generally in the $5-$10 million dollar range. Typical costs include fees of approximately 1.00% of the loan amount (which may alternatively be built into the rate) and deposits up to 2% of loan amounts (partially refundable at closing).

Regional banks have begun to loosen their LTV requirements and are willing to lend up to 75% LTV (with 80% LTV available on select deals). Such banks have been offering rates in the range of LIBOR + 2% to 3% for floating rate deals and from 5% to 5.50% for fixed rate products.

Some national lenders are lending in the <$1,000,000 space which has been tight over the last few years. These deals are typically 55-60% LTV, with rates hovering between 4.75-5% for a five-year deal, with no origination costs. Such deals have a recourse component to them which can sometimes be limited to "bad-boy" actions only.

Mezzanine Loans:

Multi-family mezzanine lenders are lending up to 80% LTV, with interest rates for mezzanine loans falling within the 9 to 13% range.

Equity:

There are numerous groups with equity funds available for multi-family residential deals, but attractive opportunities remain scarce. Equity investors should expect a preferred return between 8% and 12% (depending on the risks and nature of the deal), and 50% to 80% of the profits. Deals may include "waterfall" provisions whereby the promoter is entitled to a greater share of the profits if equity investors achieve certain IRR thresholds.

The multi-family residential rental market is stronger than it has been in years, with several high profile transactions closing in recent months and many new construction rental projects breaking ground. Some examples includeBJB Partners LLC $112 million refinance of North Side apartments, the listing of 249-unit EnV in River North which is expected to yield $125 million, sale price of $320 million for an 890-unit building at 1 W. Superior and Waterton's purchase of 509 units in a 774 unit Florida condominium project. As homeownership rates continue to decline due to the excess supply of foreclosed homes and slow economic recovery, the long-term outlook for multi-family residential rental properties continues to make them an attractive investment opportunity. According to apartment market research experts, last year was one of the best periods for landlords over the past 15 years and may mark a turning point in the short term. In 2010, rents nationwide rose an average 4.2 percent. In 2009, by contrast, landlords offered greater discounts to attract tenants, and effective rents fell 5.9 percent.

Although there are several positive indicators throughout the various real estate sectors, lending sources are still cautious. We expect the next quarter will continue to see an increase in deal flow and continued increases in optimism on behalf of lenders.

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As you review these terms, we would appreciate any feedback you have on how this survey can improve in the coming quarters. Please contact Keith H. Berk, Kristin L. Dunlap, Lawrence J. Feller, Kenneth Klassman or Ati P. Khatri with questions or comments.

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