Mind the gap

If you ever have the pleasure of riding Amtrak along the Washington-Boston corridor -- perhaps to Wilmington, Del., to visit the U.S. Bankruptcy Court -- you will hear the conductor at every stop warn passengers to "mind the gap," the dangerous six-to-12 inch space between the train and the station platform. Not only could someone be hurt slipping into the gap, perhaps even more importantly, the entire train might be delayed during a rescue.

While it may seem pretty obvious to mind the gap, nevertheless the conductor announces it again and again, at each station, up and down the line.

Likewise, in conference rooms of financial sponsors across North America, partners are hearing from senior lenders to mind the gap. In this case, however, the gap results from the decrease in leverage from where transactions were originally financed during the halcyon years between 2002 and 2007, versus where the senior lenders are prepared to provide leverage in the current market as those debts mature.

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Data from Standard & Poor's Leveraged Commentary and Data shows that the relationship between average debt multiples to Ebitda widened from 3.8 times in 2002 to 4.9 times in 2007. However, in the fourth quarter of 2008, that same ratio plummeted to 3.1 times, and that number is probably misleading as it reflects the refinancing done by the strongest credits -- steadier earnings, better collateral, etc. -- at a much higher interest rate and more conventional terms than before.

This sudden decrease in leverage is a significant cause of today's tight credit market, and it is an inevitable outcome of that "rearview mirror" competitive reality. As the lines blurred between old fashioned, credit driven commercial banking and the much sexier and riskier investment banking, with every passing month, frontline loan origination marketing folk would come back to their credit underwriting counterparts and complain that their institution was not keeping up -- losing market share by being too conservative. So each quarter, the underwriters would stretch and ratchet-up just a little more, and the statistics would come up a little higher the next quarter -- a maddening, self-sustaining spiral until the sub-prime contagion crushed the credit markets in August 2007.

In fact, this dynamic was widely recognized in the syndicated loan side of banks, and many institutions were aggressively selling down exposure to these highly leveraged, poorly structured covenant-lite loans. Unfortunately for many major financial players, word from the underwriters in syndications did not reach the proprietary trading desks, and thus we have billions upon billions of toxic assets and government rescues.

Again, as average debt leverage increased each year from 2002 to 2007, the amount of debt a financial sponsor could add to support a transaction increased. Let's calculate the average debt capacity for a company doing $25 million in Ebitda in 2007. Say the company took on $112.5 million in senior and second lien debt at a multiple of 4.5 times and $12.5 million in mezzanine debt at a 0.5 times multiple for $125 million in average debt capacity.

Using the revised debt multiples, in the fourth quarter of 2009, the financial sponsor would see debt capacity of the following: $62.5 million in senior and second lien debt at a multiple of 2.5 times and $15 million in mezzanine debt at a 0.6 times multiple for a total capacity of $77.5 million. That yields a $47.5 million refinancing gap.

The example above assumes Ebitda remains stable at $25 million, although in many cases covenants, especially in the middle market, assumed steady growth in Ebitda as the loan matured. However, in the current economy many companies face Ebitda pressure. Let's recalculate the debt using a 10% decline in 2007's Ebitda. Refinancing at $22.5 million Ebitda, the financial sponsor would see debt capacity as follows: $56.25 million in senior and second lien debt at a 2.5 times multiple and $13.5 million in mezzanine debt at the 0.6 times multiple for an average debt capacity of $69.75 million. That yields a refinancing gap of $55.25 million.

This simple example demonstrates the challenge thousands of financial sponsor portfolio companies have in the current capital markets.

There are only a few ways to close the gap, including: 1) sponsors can write a check; 2) mezzanine funds can fill it; or 3) senior lenders and financial sponsors can restructure.

Setting aside the predisposition that most financial sponsors have against ever adding more equity to an investment, there are practical considerations as well. Some funds are fully invested, or they may have internal liquidity issues, e.g., limited partner redemptions. There are often material legal restrictions preventing later funds from investing fresh capital into transactions from a previous fund, especially if the limited partners are different between financial sponsor fund II and financial sponsor fund IV, for example. Finally, equity returns from new money invested may not produce an adequate return -- the risk of throwing "good money after bad."

While mezzanine funds have been extremely active since August 2007, most senior lenders restrict the amount of debt beneath the senior. Despite the senior position, senior lenders will not allow cash to flow out of a business to make high interest payments to mezzanine lenders, and in these days it is not unusual for mezzanine funds to look for an 18-22% current pay, plus warrants, even on the strongest credit situations. Challenges with senior lenders have also slowed down the mezzanine market, as it has been hard in this environment to get senior lenders to the closing table.

For those in the corporate recovery business, the mind the gap challenge suggests a target-rich environment. Data from Thomson's VentureXpert of the distribution by sector for the 3,000-plus financial sponsor deals closed between January 2004 and August 2007 shows that consumer discretionary and industrials lead the way.

Comparing this with figures on the tightening of the leverage market, is not hard to see how half or more of these companies will have issues as loans mature.

More and more financial sponsors and senior lenders are trying to work out most of the details of reorganization before the uncertainty and expense of a bankruptcy filing. Success depends on many factors, such as capital structure simplicity, and the number of parties corralled to hammer out a deal. Generally if you can gather the parties into one conference room, there is a good chance to work out a consensual reorganization, and maybe the visit to the courthouse can be avoided or perhaps a Chapter 11 stay can be limited, brief and focused. The prenegotiated path probably means that trade or vendor debt is reinstated in full in the reorganized entity.

However, many things can upset the prenegotiated approach, such as a lender in the "club" that has its own liquidity issues, or one who takes an "irrational" holdout position. In those cases, financial sponsors are left with an alternative to walk away, or the difficult prospects facing a Chapter 11 or Chapter 7 filing under the U.S. Bankruptcy Code.

Mind the gap also has the unfortunate consequence of compressing overall valuation multiples as well, so that in today's capital markets many financial sponsors are facing the prospect that a sale of the portfolio company would yield a result that is a significant discount to existing senior debt. This dynamic has a negative impact for corporate recovery professionals, as the specter of administrative insolvency means that professional fees are at risk and may be disgorged unless appropriate carve-out language can be hammered out with senior lenders in advance.

Finally, financial sponsors and senior lenders are well aware of the gap in today's market, and there has been a symbiotic attempt to manage status quo over the past three to four months. That attempt to postpone the inevitable has been aggressively challenged in situations where there is significant bondholder debt, up to and including several involuntary petitions, to force a remarking of the capital structure. As the second quarter of 2009 gets under way, look for a rash of going concern opinions from the big four accounting shops, as many companies face grim prospects from the reality of mind the gap.

If a financial sponsor has "dry powder" and limited partners that are looking to put capital to work, the relative bargains over the next 24 months will be astounding.

Jeffrey R. Manning is a managing director with Trenwith Group LLC.

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