Highlights

  • Longer maturities can help companies through rough patches.
  • Competition is making it easier for acquirers and operators to name their terms.
  • Staying flexible with your capital structure can improve results.

Longer-duration debt helps borrowers spread out maturities.

Private equity firms and corporates in pursuit of acquisitions have tacked on as much debt as lenders have allowed, taking advantage of still-low rates. In addition, says Nizar Tarhuni, a senior analyst at M&A data provider PitchBook Data, low rates tend to result in capital structures with shorter terms, leaving acquired companies with significant debt coming due sooner than usual.

As international trade conflict heats up, growth remains tepid,[1] and market-watchers scan the horizon for signs of a downturn, private equity firms want to avoid exiting transactions at disappointing lower multiples. At the same time, corporates are looking to go into the next sour economy with a manageable, predictable debt load. “The rate on the debt isn't necessarily what matters anymore," Tarhuni says. “[What matters is] the duration of the debt that's in the financing package."

The Value of Longer Maturities

Longer-duration debt helps borrowers spread out maturities. It trades higher overall cost for a greater chance of avoiding a steep bill in the middle of a downturn. Longer duration can also protect smaller companies from a credit crunch when rates rise or lenders become conservative. By late 2018 there were some signs that mid-market companies were starting to encounter lending headwinds. “It's not only a maturity issue, but a constraining cash flow issue and an inability to access the debt markets to solve liquidity concerns," said Steve Zelin of PJT Partners in a Bloomberg report.[2]

External factors impacting companies' businesses and balance sheets can create a mismatch of assets and liabilities, if the latter come due too quickly.

So the extra time provided by longer maturities can help companies through rough patches. Tarhuni says,

If a company extends the maturity out, it's safe from having to pay off the principal during an inopportune time, and it will provide a greater chance to restructure.

Tarhuni advises that private equity firms and corporates entering into new deals or seeking to refinance existing ones would be prudent to incur debt that isn't due for at least four or five years, although each borrower faces a different situation. A Bloomberg corporate debt analyst remarks that in this market, even the most favorable capital structure doesn't protect companies from pessimism about a dissolving business model.

“As Toys “R" Us demonstrated, weak sales and nervous trade creditors can bring down a company long before the maturity dates for loans and bonds," write Bloomberg reporters Katherine Doherty and Rick Green.

Competition Among Lenders

Competition is holding the financing gates open, making it easier for acquirers and operators to name their terms.

Lenders will consider 8- to 10-year maturity and dramatically cut down on covenants in the interest of being paired up with a quality borrower.

“As credit quality slips, the capital structure becomes that much more important," Tarhuni says.

Acquirers should also be looking for flexibility — such as the option to buy back debt to deleverage — and as few covenants as possible. This has become such a popular strategy that private equity often ends up playing both sides of the aisle, simultaneously seeking covenant-less or covenant-lite loans for its portfolio companies while emphasizing seniority and security as a lender.

Bloomberg quoted Apollo Global Management CEO Leon Black acknowledging this reality: speaking of a hypothetical loan, “it always has covenants, and we try to play a more conservative, cautious role."[4]

Particularly in the middle market, relationship lenders will forego covenants as well as amortization to continue winning business. As reported by CNBC.com, “Moody's now characterizes more than 80% of new loans in the market as so-called 'covenant lite' loans," going on to quote Moody's senior covenant officer Derek Gluckman as saying, “We have never seen weaker loan covenants."[5]

Why are loan terms favoring borrowers if demand is so strong and interest rates are no longer mired at historical lows? The answer seems to be the tremendous growth in supply. According to PitchBook's Tarhuni, private debt funds raised nearly $120 billion in 2017 and are growing more than 2.5 times faster than conventional buyout funds. “This proliferation has incentivized lenders to compete on both price and terms," he writes.[6]

Corporate acquirers have other considerations besides meeting certain financial multiples, including the debt already on the acquired company's books, the available interest rate, whether the overall debt can be refinanced, and whether additional debt can be tacked on to get the deal done, Tarhuni says.

Staying Flexible

Borrowers accustomed to short-term debt during the long period of quantitative easing, or who have used a soft cap on loan duration in the past, should be careful not to become too set in their ways.

An analysis published in 2013 of over 2,700 industrial companies from 1950 through 2008 found that, contrary to conventional wisdom, most companies employ a wide range of leverage options over the long-term.

Nearly 70% of firms with known leverage data over a 20-year period would appear in at least three leverage quartiles during that time. And when leverage structure was predictable, it usually meant there was little borrowing whatsoever. “Episodes of leverage stability at individual firms do arise occasionally," write authors Harry DeAngelo and Richard Roll in the Journal of Finance report.

Capital-structure stability is the exception, not the rule, occurs primarily at low leverage, and is virtually always temporary.[7]

Ready to Help

Seeking out the best value in debt markets may mean locking in longer-term obligations now. In a few years, the formula may change again. Staying flexible and open to the best combination of lender and loan terms is more important than any set-in-stone approach to financing. PNC’s Debt Capital Markets group delivers a single source of capital, streamlined documentation, consistent pricing and terms and greater borrowing capacity. Reach out to your PNC Relationship Manager or discover more at pnc.com/dcm.