PE sponsors need to factor in Covid-adjusted EBITDA to their LBO models as deal pipeline builds for Q1 2021

Marcio Prono, JP Morgan

2020 was expected to be the year when valuations would finally come down and present a ‘perfect vintage’ for private equity buyout firms, affording them the opportunity to buy assets at more reasonable purchase price multiples.

This has not happened.

“In Europe, the deals that have been transacted have been companies that have proven to be Covid-19 and recession resilient. Most of these deals have been in the healthcare sector and technology sector. PE firms still need to pay a premium for companies that can demonstrate growth and recession resilience,” comments Simona Maellare, Global Co-Head of the Alternative Capital Group, UBS.

Speaking to Private Equity Wire, one source familiar with the topic notes that spreads on LBOs were at multi-year tight prices going into January before Covid struck. By end of March, spreads had widened significant “and it felt like the bottom was falling out of the market. We’ve recovered 80 to 85 per cent of that drop and prices remain inside five- and 10-year averages.”

LBOs understandably slowed in Q2 in Europe and the US, as PE groups exercised caution. According to Bloomberg data, there were only two buyouts completed between April and June, one of which was Clayton Dubilier & Rice’s acquisition of Radio Systems. UBS Group AG led the financing, which consisted of an all-bond structure.

There will likely be continued caution among banks involved in syndicating loans through to year-end, but one encouraging sign is that since March, leveraged finance has enjoyed a strong V-shaped recovery from the lows of March, when secondary prices on the S&P Leveraged Loan Index dipped to around 78.

“They are now back above 95, versus 98 pre-Covid,” remarks Sarah Mackey, EMEA Head of Leveraged Finance, UBS. “Many transactions that were waiting to be issued in March through May were successfully placed in the market in June and July. We’re now starting to see new issues coming to market and these are being well received.”

She adds that large transatlantic deals that can access bonds and loans in dollars and euros are being well received in the market:

“While we are starting to see a return of M&A activity, because of high price expectations from vendors we are seeing less to finance in September and into Q4; these deals are being pushed back into Q1 2021.”

Earlier this year, Europe saw the biggest buyout deal in more than a decade when German industrial group Thyssenkrupp agreed to sell its elevator business for a reported USD18.9 billion to a consortium led by Advent International and Cinven

Nevertheless, the reality of Covid-19 is that the number of LBOs will inevitably be lower this year, and could make for a crowded period of deal making in Q1 and Q2 next year.

“As an institution we have been open for business and underwriting transactions all through the pandemic,” states Marco Prono (pictured), Executive Director in EMEA Leveraged Finance Capital Markets, JP Morgan.

Squaring the economic circle

In the current market environment, the challenge for executing a successful buyout is agreeing on price.

On the one hand there remains enough uncertainty at the macro level, whilst on the other hand there is an equal amount of certainty in terms of the strength of monetary policy supporting the markets. The upshot to this is that one might, as a seller, have higher prices expectations than a potential buyer.

The optics of how both parties find a mid-point to agree to prosecute deals have changed, requiring buyers to see evidence of Covid resilience.

PE sponsors will now be asking themselves, ‘What is the company’s EBITDA and how do we get comfortable with the business plan?’

Brendon Parry is Managing Director – Private Investments at TIFF Investment Management, a non-profit outsourced CIO that invests in private equity on behalf of endowments and foundations.

He says that from a risk management perspective, the threat of another downturn before things recover is something to keep in mind.

“Forecasting cash flows today relative to the previous downturn is uniquely challenging, and the difference between 2019 year-end EBITDA, trailing twelve months EBITDA and expected 2020 EBITDA is going to vary dramatically. While it feels like prices still look high, it is challenging today to look at a trailing 12-month PPM and truly know if the prices being paid are too high or too low when you contextualise businesses and their valuations with what’s going on in the world,” says Parry.

Maellare believes there will be a softening of the EBITDA and that PE firms need to think about Covid-adjusted EBITDA when looking to buy or sell in the current environment.

“I think we will see more of a normalisation of EBITDA next year as companies go through two or three quarters to prove their businesses have stabilised. The basic assumption being made here is that there is not a second wave of Covid-19 and another significant lockdown, she says.

Lenders are still syndicating leveraged loans to finance buyouts, with Prono noting that healthcare and technology sectors are still supportive of higher leverage compared to Covid-impacted sectors:

“In general, for sectors where valuations are justifiably high because of high growth and favourable tailwinds – such as healthcare and technology – the leverage is proportionately going to be higher,” comments Prono. “But I don’t think there is a material difference in how much leverage PE firms are using to acquire companies in these sectors in the current environment, compared to pre-Covid. It is comparable on a relative basis.

“For companies in sectors facing more headwinds, the leverage is going to be lower, not just on absolute basis but on a relative basis because in those instances, the market is keen to see a larger equity cushion.”

Stretched senior deals

Against a backdrop of high PPMs in healthcare and technology and a stable secondary loan market to support issuance, one of the trends UBS has seen in recent months is investors preferring to back slightly higher rated transactions, which would mean lower cash leverage.

This creates a funding gap between valuation price and slightly lower leverage and as Mackey explains: “We need to ensure the financing we put in place for any leveraged loan can withstand a tough economic backdrop going into 2021. To bridge the funding gap we might see a trend in stretched senior deals combined with preferred equity. Otherwise, there might be issues around arriving at the right purchase price and deals won’t be completed.”

A senior stretch loan is a form of hybrid loan structure that combines senior debt and junior or subordinated into one package.

Another option is to finance the LBO will less secure debt, such as high yield bonds. As mentioned earlier, the CD&R deal this year was financed with an all-bond structure.

Bilateral deals dominate

Looking more broadly at the M&A landscape, Prono feels the tone has meaningfully changed this year.

“It feels like there are a lot more proprietary bilateral discussions that PE firms are having either with other PE firms looking to sell, or public corporations looking to go private… as well as some family-owned private businesses looking to transition,” he proffers.

Broader bank-driven auctions have been less of a feature this year, as PE groups seek to prosecute deals with companies they already have pre-existing relationships with. That being said, Prono confirms: “I am starting to see auctions surface again. But what that means is while capital is being committed over the next 60 to 90 days, any such auction-based deals aren’t likely to close until early next year.”

At UBS, Maellare further confirms the above point by adding that the buyout deals PE groups are looking at right now “are with companies that they’ve dealt with in the past but maybe decided to put the investment on hold and now ready to re-engage with them again”.

Parry explains that leading up to the summer, most of the PE managers that TIFF invests with had been focused on the health of their existing portfolios and less focused on getting new deals done but activity picked up in the third quarter.

“Many of our managers are back to operating in an almost normal manner heading toward the end of the year. Most, if not all, of our buyout managers never stopped building their M&A pipelines.  In recent months, we have seen our managers signing more letters of intent after months of research and due diligence.

“We have seen a good deal of founder-owned companies looking for growth capital and corporate carve-outs, either where a stressed parent company is looking for extra capital, or a public company is looking to refocus their business and sell a better story to the market,” observes Parry.

Digestible pipeline

For now, Europe’s M&A market comprises a combination of proprietary deals which may have a shorter fuse, in terms of speed of execution, and a more limited number of broader auctions, which likely won’t complete until Q1 next year.

“Going forward I think the rest of the year will continue to be quiet on the buyout front. A lot has been pushed out into 2021. Pricing assets accurately remains a major challenge for PE sponsors in this marketplace. And this will likely limit the number of those who transact on deals before year-end,” opines Maellare.

Prono concludes that the M&A pipeline still looks decent in terms of committed capital: “We probably still have USD8 or USD9 billion to go in Europe, while in the US that figure is closer to USD12 billion. So it’s a very digestible pipeline. Things are spread out relatively well, over the next few months.”

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