The Deals Lens – Do high times for lending mean we’re heading for a fall?
March 26, 2015
It seems like every day there’s another story in the media about lending being at an all-time high. This is especially true in the mergers and acquisitions (M&A) market where debt so often funds the majority of the price paid.
The issues getting people hot under the collar include "debt multiples", the ratio of debt lent versus EBITDA. In the old days, this multiple stood at 4-5x. Just ahead of the 2008 credit crunch it reached 7x. What worries people today is the average multiple for deals done in 2014 was at, or just above, those pre-crunch levels.
Less protection for debt holders
That's not all though. There has been a resurgence in so called "covenant lite" lending and, at least until recently, a glut of fund raises through bond issues. Both of these types of lending essentially result in less protection for the debt holders when compared to traditional bank term loans. This means that there are fewer trigger points at which lenders can intervene if a borrower starts to go off course….something that becomes more likely as the lending multiple rises.
It’s not only the brevity of bankers’ memories that has led us here but also an over-supply of money. Quantitative easing (QE) has led to a chase for yield that’s not currently being served by the government bond market. This has fuelled the corporate bond market where a yield of 7% looks very attractive to institutional investors. At the same time many of the traditional lending banks have retrenched from the M&A lending market, often due to political whim, and especially where there’s a hangover from state shareholding. This lending gap has been more than filled by a new breed of alternative lenders. These are the "non-banks" which are often pension funds, multi-line asset managers or insurance companies – again, all chasing yield to service their long term obligations such as those to pension fund retirees.
Catch-22 for borrowers
Faced with this sea of cheap money, borrowers find themselves in a quandary. Should they take all the debt on offer, even when they know it's more than they are comfortable with? Some private equity (PE) buyers are saying no, you can have too much of a good thing. The risk they run then, is that they’re uncompetitive in auction processes versus a more gung-ho bidder. For corporate entities, the over-arching goal tends to be maximising shareholder value. So, if debt is plentiful, cheap and has few covenants, then are they failing in their duty to shareholders if they don't fill their boots right now?
A question many are asking is how much should I worry and will we see a repeat of the post-crunch problems of excessive debt that can't be serviced, followed by company collapses?
I think things are a bit different this time round. Received wisdom says that we are towards the beginning of a cyclical upswing, with the consensus being that we will see at least two or three years of robust growth. This should filter down into larger company profits to such an extent that the racy lending multiples being seen today will not look so racy in a few years’ time. In the meantime, the costs of paying the interest bill are modest versus a decade ago given base rates are near to zero. This argument will hold water for a couple of years. But if lending continues to track upwards while we ride the cyclical upswing I worry that we are building a major problem for five years’ time when we may have passed the peak.
Regulation of deal multiples?
Some policy makers share the concerns I’ve voiced above. In the US we have seen regulatory caps on lending multiples. These, however, only apply to regular or regulated banks; the alternative lenders or bond markets are more challenging. My view is that policing these is unlikely to be the way forward as the markets have proven time and again that they move faster than any supervisory endeavour. Call me an optimist, but my hope is that ultimately the markets are rational and that (plus an end to the artificial impact of QE), will help them cool off. Time will tell.
To what extent do you think we’re heading for a fall due to debt availability? Will deal multiples self-correct or do they need reining in? Share your thoughts below or schedule a meeting to discuss your situation in confidence.