During my too-brief sailboat racing career in Australia, it was often necessary to cut closely between islands and shoals during long-distance events. Invariably, these games of roulette came at night and in the midst of a blow. There is little that focuses you more than perilously close waves crashing on jagged rocks as you hurtle through rough seas on a thin carbon-fiber tube in the dark. While I’ve not met a sailor that approaches serenity about these challenges, those that have been there/done that remain calm and know what needs to be done. Experience allows them to make better decisions at tough times. Meanwhile, the Posers that talked a heady game at the yacht club bar are often found in a fetal position in a bunk or, worse, causing confusion on deck – increasing risk at just the wrong time.
Even with the current deal flow drought, we’ve had a decent run in the LBO sector. Many senior and junior debt outfits have expanded teams to “jump on ship” for fortune and fame in the leveraged lending world. I would caution that there is under-weighted risk in inexperience – especially as the economic waters get choppy. Even across well-known firms, there are many lenders on-point in deals who have not yet faced their first trial under fire (or a single dash through the shoals). As I’ve talked with a number of PE professionals, there is an awareness that GPs need to keep a weather eye on the point people across the capital stack.
Over a 20 year career of working in middle market deals, I have too often seen this scenario: The hot-shot upstart lender who was given a ‘big deal’ for retention/development/bonus-potential/whatever purposes. Knewbie (I’ve written on Newt Knewbie before) may have just spent four weeks in sales training and may have done an annual review or two – but now: he wants The Big Deal, or he’s leaving! [If I am not in Founder's Circle by my first anniversary, I'll just burst!]. Here’s just a couple of examples where this can go wrong for the underlying operating company, the other lenders, and the private equity firm:
Knewbie’s inexperienced approach may rely more on arbitrary boxes and check lists to fill out pretty tables and forms – rather than a prudent due diligence approach that locates and addresses actual key areas of underwriting risk. We have all seen the frayed-copied-four-page-cookie-cutter data request (that may still have “Business Banking 1998” in the page footer), fielded infernal questions that are readily answered by a basic review of the data site (for which the lender requested 5-6 log ins but no one has accessed), and – by far the most disruptive – heard the 11th-hour objections that should have been addressed Day One before three weeks of underwriting (“why are you paying more than 5 times EBITDA if that is the average that my credit guy says LBOs should be done. Oh, and what does roll-over equity mean?”).
Never go into strange places on a falling tide without a pilot. – Thomas Gibson Bowles
Does Knewbie understand the strategy or revenue model of the target company? Does he understand the investment thesis of the PE firm? Time and again, I have seen cash flow deals dressed up as ‘out of margin’ balance sheet loans (“geez, Loan Committee, we may only have 36% collateral coverage at close – but with excess cash flow recapture, the model shows leverage gets to 0.9x EBITDA and “ta da” collateral coverage in year 4”). Thought question: Although it is possible to wring a clever structure out of a rookie lender, if the kid really does not know what they’re doing, who pays when the deal invariably does not tick to the opening day model?
Does Knewbie’s management have deep LBO experience if he leaves (yes, they may know where the best golf courses are – but can they articulate the merits of the deal if there is a stress point)? How deep is the bench at the lender (or do we have a thin front line of deal folks supported by desk-flying bureaucrats)? Are you going to have a trusted ally during a stress point or a career-man focused infinitely on internal standing – but not your deal? There will come a time over a deal horizon where some deviation from the initial deal will cause the members of the capital stack to revisit the deal. Are your lenders up to the task? Or do you have Knewbie in your deal: “Gosh, I don’t think committee would support more debt just 14 months after the initial acquisition even though debt/EBITDA is down 25% – can’t you just cut a check from dry powder for more equity to do this add-on thingy?”
While this is a bit tongue in cheek, think back to the 2007-09 cycle – who sold their paper? Who blinked? Who took the umbrella when it rained? PE pros know the importance of real, relevant experience in their operating company management and their own staff. Where is the weak link? If you are trying steer a high performance sailboat through jagged shoals in the middle of a gale, the last thing you need is sea-sick Knewbie barfing on your boots.