This Q&A was published as part of PitchBook Q1 2022 US PE Breakdown sponsored by Stout.

What are you seeing in terms of multiples and dealmaking activity with the uncertain and volatile global macro backdrop?

Most capital providers seem cognizant and concerned about the volatility in the markets as a result of the war in Ukraine and the rising interest rate environment. However, for now, these groups are in a position where they really need to continue conducting business as usual. With the confluence of these events and the Federal Reserve Board actively raising rates, many lenders and credit funds are viewed as providing a natural hedge to rising rates, due to their floating rate structures. As a result, these lenders and funds continue to attract meaningful new capital, and so much money has flooded into these funds that there is a clear obligation to put these funds to work.

How are your clients approaching due diligence and cost projections in this inflationary environment? How are they thinking about rising costs in the labor market and other input costs?

All of the companies we see are trying to better understand how they will be impacted by the currently elevated labor, raw material, and transportation pricing, as well as whether these pricing pressures are transitory or longer term. The impact on margins is also not just a factor of increasing input costs. The volatility in the supply chain is forcing companies to maintain higher-than-normal labor levels while still being impacted by the need for increased overtime labor. The lack of scheduling visibility has changed what would normally be considered a variable cost into a semi-variable cost. As a result, companies are finding it more and more difficult to deliver accurate projections.

How have sponsors thought about their own portfolio companies in this environment? Are they expecting to hold longer or utilize alternative exit routes?

While deal activity continues to be very strong, many of the sponsors we work with are anticipating longer hold periods for their portfolio companies. The volatility in various companies’ performance—including supply chain delays, labor irregularities, chip shortages, increased commodity and transportation costs, and even, conversely, the “COVID-19 bump”—make valuation of these businesses a challenge. These companies’ ability to show meaningful performance trends to the market is critical to maximizing value upon a sale. Establishing these trends will take time, and we could see hold trends extend. From a financing standpoint, we’re seeing the need for sponsors to plan for longer-term capital and to have dry powder for acquisitions and longer-term capital expenditures. Things like expandable revolving credit facilities, carveouts for equipment financing, hedging solutions, or flexible surety/bonding capabilities that could previously be solved with a band-aid approach because of shorter hold periods now require more thoughtful structures and planning to avoid potential bottlenecks for growth.

How is the current deal environment impacting the lending markets?

The level of M&A and deal volume has been so high over the past few years that lenders are drinking from a fire hydrant. Lenders are seeing more PE-led deals than ever before. This, combined with the fact that many PE firms are trying to deploy more capital per deal and use less debt, means that the lenders are generally seeing better quality credits than in the past. As a result, it is very difficult to find lenders in the market that will price risk. This is one of the reasons why groups like Stout, which have significant relationships and can find lenders that will price risk, are becoming more and more relevant to PE firms and companies that need capital but have a “story” or “risk” that needs to be explained to the market. And, naturally, this capability becomes even more valuable should the markets see any kind of downturn.

Are there any trends in the market that PE should be keeping an eye on?

As it relates to lending, we have been operating in an environment where PE firms are often able to get significant cushion to their lending covenants. We think many PE firms are likely not considering how they are being impacted by “covenant creep.” As purchase multiples are pushed to higher and higher levels, the implication is that the companies receiving these high multiples should grow more quickly than lower multiple companies. However, the level of cushion the lenders are giving on covenants is generally not increasing, and the combination of projected growth and a fixed cushion could create a future problem. For example, a company that is expected to grow at 10% and whose lender set covenants at a 25% cushion to projections will completely run out of cushion within three years. Even if the lender started with a 30% covenant cushion, this same company would have a true cushion of just over 5% after three years. While a strong economy can mask this issue, any type of blip, market downturn, or even just an extension of a holding period can expose significant risk in a PE firm’s portfolio companies. We are always particularly attuned to issues like covenant creep because our focus is on trying to find covenant-lite or covenant-flexible solutions to give companies adequate protection when there is a hiccup in the market. While covenant-lite solutions are common for companies with EBITDA of $50 million and up, we think our ability to bring these types of solutions to the middle- and lower-middle-market companies is unique.

What kinds of changes have you witnessed on the ESG (environmental, social, and corporate governance) front?

ESG is becoming a significantly more meaningful element for corporates, PE firms, and lenders. While corporates have been embracing ESG, and dedicated ESG-focused PE funds have emerged over the last several years, lenders are now setting aside larger allocations for ESG sectors. A number of lenders are now allocating 10% or more of their portfolios to ESG-related credits. Lenders’ expanded focus into these sectors has had a positive effect on several PE funds that were otherwise indifferent to ESG. To identify and secure more ESG opportunities, some lenders are offering higher levels of structure and pricing flexibility. As a result, PE funds are giving ESG opportunities a longer, harder look with the knowledge that a bit of financial engineering is available to either give some downside support or potentially enhance returns. We’re spending time with lenders and capital providers to keep tabs on who is fully allocated on ESG and who still needs to fill their allocations. Our ability to connect PE firms that are considering ESG deals with lenders that have space in their allocations can often lead to very attractive borrowing solutions. 

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