Financing Outlook for Mid-Market Companies: More Money, More Deals and Little Margin for Error

FEBRUARY 11-17, 2005

2nd Annual Texas ACG Capital Connection Financing Outlook for Mid-Market Companies: More money, More Deals and Little Margin for Error

Zoltan T. Berty valuations have increased from 4-6 times EBITDA Financing Considerations CapitalSource Finance in 2002 to 5-8 times EBITDA today. While the short-term financing outlook is Given these trends, it’s no surprise that M & A indeed promising, certain worrisome factors The flow of capital into the deals also are on the upsurge. According to warrant close attention. Though the economy middle market that began in mid- Buyouts, there were approximately $136.5 continues to grow (many analysts expected a 2003 became a veritable torrent billion in disclosed buyout deals for U.S.-based GDP increase of 3.6% in 2004), its engine — last year as lenders of all types companies in 2004, up 45% from 2003 and nearly consumer spending — could become stalled by moved aggressively to build 600% from the doldrums of 2001. M & A deal excess debt. Since 2000, private household debt their portfolios. This influx of flow is likely to remain strong throughout 2005, has soared by $2.52 trillion, or 36%, and now is new competitors eager to make particularly in hot sectors such as retail. 86% of GDP — far above its 34-year average of deals considerably loosened credit, gradually Rising valuations also mean that buyers are 58%. Interest rates no doubt will continue to climb. boosted debt multiples and compressed pricing. seeking more financing to acquire businesses. Plus, uncertainties relating to geopolitical In addition, valuations rose and M & A activity With intensifying competition, lenders have, been developments, oil prices and other variables may heated up. For middle market companies inter- willing to offer higher levels of debt at attractive unnerve financial markets, increasing the ested in leveraged buyouts, growth capital and pricing. Today, senior debt in the middle market likelihood of a sudden retrenchment in credit. recapitalizations, 2004 brought more and better is available at 3 - 3.25 times EBIDTA — up al- Clearly, lenders will continue to pursue middle- financing alternatives than at any time since the most a full point from 2002 levels. Mezzanine market “trophy” businesses, i.e., those market mid to late 1990s. lenders have been willing to lend from 4.0 - 5.0 leaders with defensible niches, high EBIDTA What’s on the horizon for 2005? For the times EBIDTA, depending on the size of the margins and superb management. Yet, it’s also short term, it appears the positive trends are business, and borrowers also have taken true that lender aggressiveness has its limits, and likely to continue. Yet credit markets are advantage of a strong market for B (or “junior that valuations and debt multiples likely are at, or notoriously cyclical, and the current surge in secured”) loans, which are often used to fill the near, their peaks. Moreover, the increase of highly lending has proceeded at an uncommonly swift gap between senior and mezzanine debt. No mat- leveraged balance sheets, combined with market- pace. Moreover, leverage is a double-edged ter the loan type, the amount of obtainable debt place uncertainties, compounds risk, leaving sword, since highly leveraged balanced sheets will vary depending on the size of the company, businesses with little or no margin for error. Under increase companies’ vulnerability to adverse de- its balance sheet assets, the quality of its earnings these precarious circumstances, smart borrowers velopments such as steadily rising interest rates history, and the proposed equity contribution. would be well-advised to work with lenders who or sudden pullbacks in consumer or commer- are committed to their market sector, have the cial spending. At CapitalSource, we are opti- Size Matters resources to withstand any sudden downturns mistic about middle market financing opportu- This rising tide of capital has likewise lifted and can help them move quickly to capitalize on nities, especially for select, under-capitalized the lending prospects for companies in the lower short-lived business opportunities. companies with solid fundamentals, a seasoned end of the middle market, i.e., those with less management team and a viable business than $10 million of EBITDA. Most have ABOUT THE AUTHOR strategy. At the same time, both lenders and benefited from improved leverage as their total Mr. Berty is a Development Officer within borrowers should recognize the heightened debt (senior plus mezzanine) multiples have in- CapitalSource’s Corporate Finance Group. His risks associated with current market conditions creased from roughly 3.5 - 4.25 times EBITDA. primary responsibility includes sourcing middle and consider their decisions accordingly. Lenders are not nearly as prevalent in this sec- market, cash flow based senior and mezzanine tor of the middle market because of the smaller financing transactions by working closely with Higher Valuations Require More Debt loan amounts and the heightened risks for com- private equity sponsors, strategic investors, Perhaps the most positive trend for middle panies of this size. Consequently, these borrow- financial intermediaries, and other lenders. market businesses over the past few years has been ers are paying on average about 2% - 3 % more Mr. Berty holds a degree in Accounting from the marked improvements in valuations. By late for senior debt than larger entities. At the lowest the University of Southern California, and he is 2003, purchase price/EBIDTA multiples had reached spectrum of the market (companies with less than a CPA. He is married, has three children, and their highest levels since 1999. Generally speaking, $3 million EBITDA), capital remains scarce. resides in Newport Beach, CA.