Refinancing Debt & Funding Buy-and-Build Strategies

M&A activity has slowed as a result of rising interest rates and asset valuation dislocation. What has this meant for portfolio companies that have not been exited as early as sponsors anticipated and are approaching debt maturities?

Jennifer Murray:

Five years ago, sponsors were operating on the assumption that portfolio company hold periods would be around four years, and lenders were providing debt facilities with tenures of between five and seven years. 

Of the deals we have funded in that vintage, fewer than 10 percent have reached an exit to date. Dealmakers have encountered this perfect storm of choppy valuation markets with deal processes called off, shuttered IPO markets and the fall-out from COVID disruption and economic headwinds –  often placing sponsor plans for management team succession and significant change on hold. It has meant that sponsors and lenders have increasingly been engaging in early conversations about the options for prolonging the debt runway, and exit periods.

This has opened up interesting opportunities. For example, we have been approached by sponsors whose incumbent lenders had provided funding to their portfolio companies for four to five years and can’t extend the loan period any further. In other cases, sponsors have conviction that, by refinancing with a new lender and extending the hold period, they will be able to exit in the next two to three years in a way that will fully capture the value of an asset.

Is Shawbrook open to these refinancing opportunities and how do you assess whether a refinancing enquiry is an attractive option, rather than kicking the can down the road for an asset that simply hasn’t been able to deliver on its plan?

Jennifer Murray:

There is definitely a requirement at the moment for private equity to innovate and to drive value differently. Through the economic headwinds of recent, the organic growth hasn’t been there for many assets.

Against the current backdrop, many clearing banks are taking a cautious approach to refinancing, especially if they are already the incumbent lenders and have had to work through various challenges with these businesses over the last couple of years. It is hard to go back to a credit committee and request an amend-and-extend deal for an asset that hasn’t grown as fast as anticipated. Private debt funds, meanwhile, are sensitive to time horizons because they are geared up to make distributions and recycle capital. It doesn’t suit the model to have prolonged tenures.

At Shawbrook, we have been able to position ourselves in a distinctive way when it comes to these refinancing scenarios. We don’t have the timeline sensitivities of the funds, and we can be more flexible than a traditional clearing bank.

When we look at these opportunities, we ask ourselves whether an asset represents a safe place to deploy capital, and whether a refinancing now presents a sponsor with the window to generate a return in two to three years that will be as good or better than what can be delivered now in a new buyout.

Could you go into a bit more detail, then, about how you are filtering these opportunities? What specifically do you want to see?

Jennifer Murray:

We've been quite selective, and we have been minded to work with sponsors  we have a good relationship with. In refinancings you are not likely to have access to the same level of due diligence you would see in a new deal situation, so you have to be in a position to have an open dialogue with the sponsor and to really get under the skin of the business. That trust, and the ability to have a frank discussion about the value of business, with a sponsor that you know and have worked with before, is so important.

What we don’t want to be doing is derisking a sponsor for the sake of derisking them. We want to see that they still have skin in the game, that there is still equity upside for the sponsor if they hold an asset for another two to three years, and that the sponsor is still very focused on taking the business to exit. The equity story is central, and in these situations we will explore options to include equity kickers or warrants to ensure that there is alignment between the sponsor and ourselves.

I mentioned management teams and succession earlier, and this is another item we look at in refinancing situations. We tend to fund several first-time buyouts, so inevitably there tends to be that point of succession in those deals. COVID, inflation and interest rates have put those succession plans on hold, but if a sponsor approaches us about a refinancing to support an extended hold, we want to see that succession exit team in place already. We also want to have the conviction that if we do support a refinancing, that this is the right team to drive the business forward.

Finally, we want to see that the business has had stable, steady Ebitda growth performance. It may not have been the stellar performance that was hoped for five years ago, but if a business has managed to maintain a steady, solid level of Ebitda despite all of the headwinds; and has proved resilient; it makes a big difference.

In leveraged finance, the art behind the logic is to know when to get in and when to get out, and for us, that is why we see the potential to make some good returns by being a little bit more innovative and looking at things like kickers and warrants when supporting clients in these refinancing scenarios.

In addition to refinancings, funding buy-and-build strategies seems to be another key channel for deployment at a time when new buyout and exit volumes have been tepid. Is this an area where Shawbrook has seen opportunity?

Jennifer Murray:

Buy-and-build is a great way for sponsors to drive value and – circling briefly back to the refinancing and maturities conversation – if a sponsor wants to extend a hold period because there is a buy-and-build opportunity, that is a much more positive story than just pushing back a maturity because the exit market has been challenging. 

Even though the broader M&A market has been flat, I do believe the dynamics are different when it comes to smaller companies run by management teams and owner-managers that have been through the mill with COVID, inflation and interest rates. They  want to sell and bring in the capital to take their businesses forward after the stasis and headwinds of the last couple of years. 

There is significant opportunity and willingness to transact in this part of the market, which is supportive of buy-and-build. If I look at our current portfolio, around two-thirds of the sponsor-backed businesses we are working with have done a bolt-on acquisition or taken on capital to grow through acquisition. The buy-and-build pipeline is looking very strong.

Sponsors are also being innovative. They are looking to roll-out rapid buy-and-builds in areas like accountancy and professional services, and we also see sponsors forming earlier stage platform companies, or forming new platforms by combining two or three very small assets and then using that as a launchpad for a consolidation strategy.

Overall, a portfolio company that has the right management team in place can execute acquisitions and is ready to run hard at it for the next two to three years, presenting an exciting opportunity for investors and lenders.

As a lender, what are you thinking about when putting a financing package in place to support a buy-and-build?

Jennifer Murray:

The challenge from our perspective is to strike that perfect balance between flexibility and control.

Private equity firms will often come in at pretty low leverage points at the start of the buy-and-build play, and then once they have got under the bonnet and figured out what to do with a new platform, they will look to add more gearing and potentially follow-on equity too.

As a lender, we want to put a package in place that endures and grows with the plan. We want to make sure that the sponsor is not hamstrung in anyway by the funding package. Equally, we never want to end up in a situation where the platform is underperforming, but the sponsor is forging ahead with bolt-ons and inflating a massive balloon of earn-outs and deferred considerations that are going to be nigh on impossible to fund down the line.

Finding that balance requires a specific skillset. There is much more work done upfront to understand the sponsor’s sector knowledge and the management team’s M&A and post-deal integration capability. You also have to make sure that you get the leverage thresholds and covenant packages right.

Financing a buy-and-build is quite a different proposition to funding a straightforward MBO, and it is a niche requirement where we are very strong. Buy-and-build strategies are right in our sweet spot.