“Ignorance more frequently begets confidence than does knowledge”. – Charles Darwin
I am often asked whether middle market LBO lending is specialized. To a great extent, the answer is “yes”. Certainly, there are essential elements of transaction analysis, underwriting, and account management in middle-market leveraged deals that require a more sophisticated approach than is typically demanded in plain-vanilla middle market lending. We are undertaking a series of posts that will provide more detail around these points and will illustrate how other professionals are thinking about the topics, as well. Suffice it to say that there are as many approaches as there are LBO lenders – some are thoughtful and effective – many are ad hoc and ripe for catastrophic outcomes. And as we have noted in other posts, there are real risks to inexperienced lenders.
The concept for this thread started as I re-read a (recommended) guest article in Buyouts by Stephen Fields on “Lenders Going Into Deals Eyes Wide Open”. Setting aside the overly optimistic assertion about the group as a whole, the article provides evidence that leveraged lenders are taking steps to enhance their due diligence processes based on learnings from run up to the Great Recession. One passage hit squarely on a major pet peeve encountered all too frequently in due diligence efforts: Fields noted, “Meaningful due diligence is more than collection of random pieces of information and checking boxes on a form. Although it is necessary to understand the nature of assets being acquired and the liabilities being assumed, most acquisitions are based on the value of future cash flows and particular attention should be paid to those issues which affect this important metric.”
Herein lies complicating factors for a dyed–in-the-wool traditional balance-sheet lender attempting to enter an environment where a very different set of practices is more effective – e.g. moving from formulas and borrowing bases to leverage multiples, free cash flow analysis, scenario evaluation, enterprise valuation, etc. While field exams and appraisals have their place, diligent underwriting would also include a true grasp of the business model, industry dynamics, competitive landscape, etc. and how those impact meaningful scenarios around ability to repay complex debt obligations. In the majority of cases, leveraged deals are getting done where long-term or persistent collateral shortfalls exist, one should have a real comprehension of the drivers of both cash flow and enterprise value. Treating the deal as an “out of margin” asset-based stretch facility (that comes into margin in, say, 3 or 4 years) is naive. Recognize the opportunity for what it is and underwrite accordingly. But that cannot be done unless the underwriter has the skill set to do that effectively.
All that said, I have seen a number of middle market lenders “get it” and invest the time to learn new practices to stay on top of leveraged transactions pre- and post- close. As I tell teams I consult, this type of lending is not a “set it and forget it” game where one waits for compliance certificates to roll in and an analyst to spread historical financial results. Heavy lifting on leveraged deals happens “T+1” where staying on top of the execution against an investment thesis is accomplished through active and timely on-going due diligence and account management. Again, this often requires a greater level of attention and follow-up than a “Finder-Minder” model of business development-portfolio manager structure has heretofore dealt with.
While certainly not universal, the old saying in turnaround lore goes: “by the time a banker knows there is a problem, it has been there much longer that he realizes, it is worse than he thinks it is, and it is getting worse quicker than he believes.” Lenders that hope to be successful in the LBO environment must come equipped to address the challenges and opportunities this market presents.