Commentary: Credit market strong, but caution is needed

On March 9, the current bull market — the longest on record since World War II — reached its 10th anniversary. Such a milestone should be cause for celebration. But as the distance grows from the global financial crisis, the number of participants with experience navigating downturns also gets smaller.

Consider, for instance, that most deal-makers in their early to mid-30s have yet to encounter a recession throughout their professional careers. But even those longer in tooth, who recognize the catalysts that led to the last recession, remain unsure as to what could trigger the next one. While this uncertainty is doing little to slow deal activity, many have turned their attention to the debt markets for clarity, recognizing credit as the fuel that drives mergers and acquisitions.

The good news is that 2019 is in many ways indistinguishable from last year. It's certainly not a market without risk, but the opportunity set is supported by an economy showing persistent and strong growth trends, healthy corporate fundamentals and an M&A landscape — attracting both financial and strategic buyers — as dynamic as anytime in recent memory.

To get a sense of how long these conditions can endure, however, it helps to understand the supply and demand characteristics influencing M&A activity.

Bain & Co., in its 2019 Private Equity Report published in February, quantified that dry powder for alternative asset managers hit the $2 trillion mark across all fund types last year. This reflects the demand for alternatives in institutional investors' collective hunt for yield amid a low-interest-rate environment. Private debt was just as popular among asset owners, growing at a more than 30% clip, according to the same Bain & Co. report. So on top of the record levels of capital sitting in private equity coffers, credit is also readily available at borrower-friendly terms.

Many of the trends driving private equity represent a continuation of the past five years. The game changer, however, has been the re-emergence of the corporate acquirer, as strategic buyers have moved aggressively back into the market. Bolstered by the 2017 tax legislation, which cut the "headline" corporate tax rate to 21% from 35% and included provisions around accelerated depreciation, strategic buyers have again become a credible force in auctions.

This marks a distinct shift. Private equity sponsors, for the past few years, had been paying more than strategic buyers, which goes against conventional wisdom given the lack of synergies. But the combination of private equity sponsors who have to put capital to work, and strategics who now want to, has created the most competitive environment for deal-making in recent memory.

Anecdotally, family offices like corporates have also become more active — both as limited partners and increasingly as direct investors — while independent sponsors — private equity firms working without a committed fund — are becoming bigger players in the small and lower-middle markets. Factoring in debt levels that have grown steadily over the past three years — with most investments incorporating leverage north of 6x or even 7x EBITDA — it's no wonder average entry multiples in private equity continue to hover above 10x.

In light of the valuations, it's clear that buyers are willing to pay up for the best assets, particularly in certain sectors. Healthier deals — involving good companies that generate consistent cash flow — will get financed in just about any environment regardless of the conditions. And these assets remain available, whether it's through private equity sponsors seeking exits, founder-led companies pursuing succession or even publicly held targets.

The current mood, however, is better represented by deal flow in industries deemed to be out of favor, such as traditional brick-and-mortar retail, or more cyclical industries, ranging from hospitality to auto parts. But in both cases, elevated multiples have been a motivating factor for sellers. Even distressed opportunities are generating a level of buzz among liquidation firms and asset-based lenders. This was evident in the competition that emerged for the recent Sears debtor-in-possession financing.

The prices being paid reflect a slight imbalance in which the supply of assets can't keep pace with the robust demand from acquirers, although comfort is being found in accelerating bottom-line growth rates. Still, high multiples, premised on value creation and leverage, add risk.

What has been remarkable amid the continued run has been the ability of buyers to discount the noise around growing geopolitical risks, particularly around trade and tariffs. Add ongoing interest-rate uncertainty and currency volatility into the mix, and it can be difficult to map out long- or medium-term strategic plans. This is why so many in M&A look to the fixed-income and lending markets as a proxy for what awaits.

Given the uncertainty, experienced lenders have been focused on underwriting standards and have become much more cautious with regards to any EBITDA adjustments that may appear overly aggressive. Many have also increased the surveillance activity in certain industries in terms of the information requested from borrowers. This scrutiny is justified given where we are in the cycle and the propensity for covenant-light loans.

For lenders that have experienced multiple cycles, company fundamentals are the No. 1 factor that impacts performance and influences risk appetite. This is why earnings trends are monitored so closely and where lenders find conviction even as the bull market enters its second decade.

However, the few private credit players who have experienced multiple credit cycles should recognize it's the "unknown" unknowns that often take the market by surprise. The more experienced players, as a result, are focusing that much more closely on lending standards and have become more cautious about EBITDA adjustments. Valuations are also being scrutinized, which may speak to the pullback in private equity-driven deal activity in the first quarter.

In the credit business, no matter how loud the music is playing, you need to think about what happens when the music stops. And what you do at that point, is typically where experience comes in.

Theodore L. Koenig is president, CEO and founder of Monroe Capital LLC, Chicago. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.