The state of the capital markets is a very significant factor impacting merger and acquisition activity.  A recently-published academic study of private capital markets provides insight into current conditions.

Pepperdine University’s Graziado School of Business and Management conducts a semiannual survey of conditions in private capital markets.  The most recent report gives insights into the impact of  the turmoil and changes in the credit markets on financing options available today.

Commercial banks continue to be the cheapest form of capital, with interest rates averaging 6% to 8% on commercial loans.  However, banks in the survey reported that they will typically end up to 2.5 times EBITDA (earnings before interest, taxes, depreciation and amortization) versus as much as 5 – 6 times EBITDA during expansive lending cycles. In addition, banks are much more likely to impose significant restrictive covenants on borrowers, including limitations on additional borrowing, limitations on distributions and executive compensation and required levels of earnings coverage.  Unanticipated difficulty meeting financial covenants can make life very difficult for borrowers.

Asset-based lenders typically expand during tight credit periods and today is no exception.  The survey breaks down asset-based lenders nto three tiers, Tier I, making loans in excess of $10 million, Tier II, making loans from $2 to $10 million and Tier III, making loans of less than $2 million.   The survey reports all-in interest rates of 8% to 10% for Tier I loans, 10% to 15% for Tier II loans and above 18% for Tier III asset-based loans.  These loans typically require relatively few covenants and limited or no personal guarantees.  In addition, although interest rates are high, these lenders do not typically receive equity participation.

Mezzanine lenders provide loans and receive equity participation in the form of warrants.  Mezzanine financing is subordinate to senior debt and does not usually have personal guarantees.  Accordingly, they carry a high interest rate.  The survey shows that rates on mezzanine financing have risen to the 12% to13% for a loan in the $2 to $10 million range.  Mezzanine lenders seek approximately one-third their return from the included warrants, so they are looking for returns in the 18% to 20% range.

Mezzanine lenders typically include restrictive covenants which can allow them to accelerate the maturity of a loan in the event of uncured defaults.  They also usually charge a variety of fees to the borrowers.  Nevertheless, mezzanine financing can be very attractive.  Combined mezzanine and senior debt may be available up to 3.5 to 3.75 times EBITDA.

Many mezzanine lenders only do so-called “sponsored deals” in coordination with private equity firms.  They look for some of the same characteristics that private equity firms do – strong management, solid fundamentals and an attractive financial risk analysis.

Private equity firms remain active in the marketplace.  The survey provides some information on expectations of private equity firms.  Private equity firms invest in a wide variety of  businesses, with service businesses leading with about 26% of transactions.

In terms of transaction size, only 17% of private equity firms will consider an investment of less than $2 million.  60% will not consider an investment of less than $5 million. 39% will not consider an investment of less than $10 million.

Considering that private equity firms target an equity as a percentage of total invested capital between 20% and 50%, a $5 million investment for a 65% control position would suggest a total capitalization of $15 million to $40 million.    It would take a minimum of about $3 million in EBITDA to support a transaction at the low end of this continuum and about $10 million at the top end.

According to the survey, private equity firms are seeking minimum annual revenue growth of 5% to 20% over the next five years and minimum EBITDA growth of 5% to 20% over the next years as well.

Private equity firms reported hurdle rates (minimum acceptable rates of  return)  of 20% to 30% for new investments with a median of 25%.

As an exit strategy, most private equity firms will be targeting either the sale to a public company (35%) or to another private equity group (34%) as an exit strategy with an investment horizon in the five year range.

The data included in this article is survey data only and may not reflect the entuire range of possibilities.  While the study was only published in August 2009, the data was gathered in  March and April 2009.  Given the turbulence of credit markets during the past year, the data may not be representative of current facts, however it does give a reasonable overall picture of the private capital market today.

You can  download a copy of the survey at http://bschool.pepperdine.edu/privatecapital

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