In my 30 years as an investment banker to private and family-owned businesses, I have never seen the borrowing climate for deals change so sharply as it did in 2022. Financing for M&A and private equity transactions deteriorated dramatically as the year progressed, with third-quarter M&A financing down 70% from the previous quarter and buyout financing during the period less than half that completed in the first quarter.
Why? Ask the Fed. Belatedly concluding that its tepid measures to reduce inflation to its 2% target weren’t working, the Fed in mid-2022 initiated four consecutive 75 basis point rate increases. The velocity and size of these rate increases caught people off guard. Virtually overnight, entities seeking financing encountered a reversal of easier credit conditions and resetting of risk thresholds by lenders. What a turnaround from credit markets that since 2017, apart from a six-month COVID-related hiccup in 2020’s first half, favored borrowers.
John Solimine, head of Verit Advisors’ Debt Capital Markets, notes how quickly and by how much SOFR, the baseline borrowing rate by which financing loans are priced, has surged. From essentially zero at the beginning of 2022, it stands today at 3.8%, having been as high as 4.2% in November. Borrowers and lenders have had to quickly recalibrate expectations to this new environment, which is not expected to subside in the near term.
The impact of the higher cost of capital on all borrowers, including ESOPs, is severe as companies haven’t been exposed to this type of credit environment in many years. As 2022 began, a PE sponsor seeking to finance the acquisition of a middle market business could reasonably expect to borrow at somewhere between 4-5% from a commercial bank. Only 10 months later, that same borrower could expect borrowing costs of 7-8% or higher.
In turn, businesses’ larger cash interest burden means they can sustain less debt. Investment bank William Blair & Co. in its third-quarter review of leveraged finance noted the annual cash interest burden of the leveraged buyout of a $30 million EBITDA business would be roughly $12.6 million under typical conditions. Today, with higher interest rates and wider spreads, that millstone would exceed $19.0 million.
Consequently, lenders are intent on inserting fixed-charge coverage ratios and other loan covenants in new borrowings. “Covenant-lite” financings are now obsolete; lenders now insist on covenants as a way to flag troubles, providing an early warning of potential financial distress.
Today’s underwriting is more stringent as lenders looking to deploy capital at higher interest rates reduce the overall size of their loan commitment and introduce other structural protections. These include accelerated amortization schedules and, potentially, recapture structures for excess cash flow that require such cash generated by the business be used to reduce debt.
Do not expect the high-rate environment to abate soon. The Fed’s commitment to holding inflation to 2% will translate, in the view of one observer, to a projected SOFR peak of 5% in the second quarter of 2023. By this firm’s estimate, SOFR will remain above 3.5% until mid-2026, producing sustained borrowing rates in the mid-to-high single digits.
With these capital markets pressures, are there any silver linings for potential sellers? Actually, several.
One surfaces from the greater flexibility employee stock ownership plans (ESOPs) give sellers in structuring their transactions versus traditional M&A transactions. Because ESOP transactions don’t typically rely on such a high degree of external financing and possess corporate tax benefits – prized by lenders in the current credit-restricted environment – they are relatively easier to complete.
Financing for M&A and private equity transactions deteriorated dramatically as the year progressed
Reflecting the more difficult environment for traditionally financed deals, we have seen increased interest in partial ESOP transactions. With these, only a portion, say 30% of the equity is sold to an ESOP. Typically, financing for a partial ESOP can combine third-party financing and/or seller notes. Especially in this constrained environment, lenders like partial ESOPs with their lower leverage profile and overall debt service over a 100% debt-financed buyout.
For sellers, while delivering less than 100% liquidity at close, a partial ESOP is preferred over an auction of the entire business at unsatisfactory terms. It also offers a way to diversify and take some chips off the table while retaining the full panoply of choices down the road. Completing a partial ESOP transaction leaves open the opportunity to realize the value of the business by doing a 100% ESOP transaction or terminating the ESOP and selling to a PE firm or competitor. In short, a partial ESOP preserves options for future strategic alternatives.
One client selecting this route had weathered 2007’s financial crisis and, 13 years later, COVID. Given the possibility of a recession and the reality of higher interest rates, he considered it prudent to diversify his and his family’s holdings by completing a partial 30% ESOP. Even during this challenging market, we secured favorable third-party financing and believe he is likely to complete this transaction on terms attractive to him and his family.
A second positive: unprecedented interest we’re seeing from lenders. More than a dozen different commercial banks attended the recent ESOP Association conference, and many have established dedicated ESOP lending groups. Their participation signals an increased understanding of the ESOP structure’s benefits in terms of lower leverage and greater business stability as well as their heighted commitment to financing ESOPs.
The relatively new willingness of nonbank lenders to provide capital directly to non-PE-owned ESOPs presents a third source of optimism. Historically, nonbanks limited their lending activities to PE firm-sponsored transactions. But as interest rates rose, putting pressure on existing buyout loans, nonbank lenders sought to diversify their loan portfolios. Again, offering lower leverage, loan portfolio diversification and greater stability, ESOPs increasingly appeared an attractive alternative to more highly levered PE firm LBOs. As more entrepreneurs comprehend ESOPs as a potential liquidity event, we expect nonbank lenders will become an even more important source of capital.
A final, important bright spot: ESOPs’ significant tax benefits. They become especially attractive when interest rates are high because of the corporate tax benefits. In addition, depending upon how the ESOP is structured, a portion – and, in some cases, all – of the company’s earnings are tax-exempt enhancing a borrower’s ability to service debt.
Despite the undeniable challenges higher rates pose, an ESOP structure’s flexibility proves a boon to sellers of private and family business. While always of value, these benefits are especially significant now and should be explored as a core exit strategy.
