Consulting the Crystal Ball with WhiteHorse Capital
WhiteHorse U.S. executive managing director and CEO Stuart Aronson and president and global head of origination Pankaj Gupta join the Conversations podcast
After the ups and downs of 2023, the M&A market has been widely predicted to see a return to normal in 2024—but not everyone agrees with that assessment. Stuart Aronson, executive managing director and CEO of WhiteHorse U.S., and Pankaj Gupta, president of WhiteHorse U.S. and global head of origination, join the podcast to share their predictions and insights on what’s next for inflation, underwriting standards, portfolio performance, and more.
Middle Market Growth: Welcome to the Middle Market Growth Conversations podcast, I’m Carolyn Vallejo. In the first few weeks of 2024, dealmakers may be wishing for a crystal ball to consult with their questions about deal volume, portfolio performance and geopolitical impacts in the coming year. Here to offer their expert insights are Stuart Aronson, CEO of White Horse Capital, and Pankaj Gupta, their president. Stuart and Pankaj, welcome to the podcast.
Pankaj Gupta: Thank you, Carolyn.
MMG: Stuart, let’s start with you. What have been some interesting market trends you’ve been watching over the past couple of years?
Stuart Aronson: In 2021, the markets were extremely aggressive and very, very busy and lenders in what was a low interest rate environment and a benign economy were extremely aggressive with deal structures and pricing back in 2021, where we regularly saw leverage of anywhere from 5 to 8 ½ times. That was off of adjusted synergized run rate EBITDA such that we thought the EBITDA multiples that were being put forth in the marketplace were often from 6 to 10x, and the cash flow multiples, the cash flow, the EBITDA minus Capex to debt, were often in the range of 10 to 14x.
Back in 2021, we were running sensitivities to rising interest rates and it became clear to us that those deals would not survive well in a higher interest rate environment. And so we did avoid a lot of those deals, and we focused in on the lower mid-market non-sponsored markets to find credits that we thought were more appropriate risk return.
That changed dramatically in 2022 when, in the early part of the year, the markets broke. People became aware that interest rates were going to go up and that the economy might not be as strong.
We also know that there were some players in the market that ran into portfolio problems partially based on what they did in 2021 and so for 2022 and for much of 2023, the markets were very much lenders markets where leverage multiples were down one to three terms, loan to value came down under 50% for very consistently under 50%. We saw deals actually ranging from 25% to 50%. And pricing went sky high, prices ranged up 100 basis points or more.
That trend of conservative structures and high pricing continued through the end of 2022 and into the beginning of 2023, and that tight market for financing actually led to a significant market slowdown in 2023, where sellers of assets were afraid that the bad financing market would lead to them not getting the prices they wanted in selling their assets. So a lot of people who otherwise would have sold in 2023 held their assets back. We saw that start to resolve itself in late 2023, as direct lending dollars became more available [and] the views on the economy became a little more sanguine.
There was a view that interest rates were likely to come down in 2024, and all of those things combined to lead to a slight resumption of M&A activity in Q4 of 2023 and that has extended into 2024 with a significant move in the markets to lower price, to more aggressive structures. And so far, what we’re seeing is that there is a resumption of M&A activity in 2024 that is a significant bump to what we saw in 2023, although not yet back to 2021 levels.
MMG: Pankaj, turning over to you: How have you seen underwriting standards change or develop over the past few years in conjunction with, or perhaps as a result of, some of these market trends that Stuart just mentioned?
PG: Well, it really dovetails nicely with, I think, the commentary that Stuart just provided. And so if you go back to, again, 2021, which was the peak of the aggressiveness in the market environment that we saw, we were seeing folks significantly loosening their underwriting standards. We were seeing deals getting done at very high leverage multiples for cyclicals. We were seeing adjustments to EBITDA that we thought were unsustainable and not likely to turn into cash flow, and overall, we were seeing risk enter into the marketplace that, we thought, was frankly imprudent and very, very aggressive.
Then, as we fast forward into 2022 and for most part of 2023, we saw a lot of that prudence come back into the market from an underwriting perspective. Cyclicals, although they were getting done in the marketplace, we saw leverage multiple starting to come down, we saw loan to values coming down, and we saw EBITDA adjustments largely coming down, as well as a percentage of the total EBITDA that people were lending off of. In addition to that, the covenants and the document terms that we saw coming back into the market in 2022 and 2023 became much more lender-friendly than they were in 2021, so overall a picture of more rationality that came back into the market over those couple of years.
[In] the early part of 2024 we’ve seen a bit of a loosening again in those underwriting standards, we’ve seen leverage multiples start to creep back up a bit and again, structures, document terms, adjustments to EBITDA, leverage multiples, loan to values—all of the various credit metrics that we take a look at have also in the marketplace gotten a bit more aggressive, not to the levels that they were in 2021 by any means, but definitely a bit more loosening in 2024 here in the early stages than there was in the past couple of years.
[In] the early part of 2024 we’ve seen a bit of a loosening again in those underwriting standards, we’ve seen leverage multiples start to creep back up a bit and structures, document terms, adjustments to EBITDA, leverage multiples, loan to values—all of the various credit metrics that we take a look at have also in the marketplace gotten a bit more aggressive.
SA: I would just add that in 2021 one of the things we saw happening was lenders were starting to do what we refer to as diligence light, where lenders were committing to deals without doing full due diligence, basically relying on the diligence of the private equity firm as a proxy for the due diligence that they would have otherwise done. We didn’t see that at all in 2022 or 2023 and the more conservative credit environments. But here, in early 2024, we’ve already seen a couple of examples of firms doing diligence light underwriting which is certainly a concern given that the focus of a private equity firm and the focus of a lender should often be very different.
MMG: Right. So we’re starting to see some trends develop already only a few weeks into 2024. Stuart, what is your outlook for the rest of the year?
SA: Based on what we’re seeing right now, knowing that there’s once again plenty of capital to serve the needs of the M&A market both from the banking CLO community and from the direct lending community, we do expect it to be an aggressive year. In aggressive market environments, we tend to focus our attention more on the smaller private equity firms who are more relationship-oriented and how they make lending decisions, and also they tend to be more conservative in the financings they put on their deals. They don’t push the leverage or structures as high as some of the larger private equity firms. We also focus in on the non-sponsor market.
That non-sponsor market in the middle market and lower mid-market is a much more conservative market than the sponsor market where leverage in that non-sponsor market typically runs from anywhere from two-and-a-half to four-and-a-half-times and loan to value is typically between 30 to 50% on the credits. So when market environments get aggressive like they were in 2021 and they appear they will be again in 2024 we pivot to covering market segments where we think there are fewer competitors and better risk return.
MMG: And because you operate, as you mentioned, within these smaller mid-market PE firms, and within the non-sponsor market within the lower and the middle market, I’m assuming here that these spaces are mostly unaffected by global geopolitical factors that might be stirring in some of the larger markets that we’re seeing right now.
PG: So, Carolyn, we would agree with your assertion there. Most of what we do as well as what most of the middle market and the lower middle market folks on our U.S.-based businesses with predominantly U.S. customer bases and U.S. supply chains and so while, of course, we are focused on the various wars that are occurring overseas and the geopolitical factors, we believe that fortunately, we are largely insulated from a lot of those occurrences.
MMG: Excellent, okay. Stuart, what about your predictions for portfolio performance in 2024?
SA: We have a more conservative outlook than a lot of players in the marketplace. We think that inflation has not yet been fully tamed based on what we see going on with our portfolio companies where there’s still wage pressure and raw material pressure and portfolio companies are still having to pass along price increases.
As a result, we don’t think that rate cuts are likely to come as early or as frequently as many people have predicted for 2024, and we believe that the higher rates in the market will slow down the economy. That doesn’t necessarily mean that we think there’ll be recession in 2024; we just think that there will be a softening economy in 2024, and that might extend into 2025 and so we’re taking a cautious approach, especially to companies that have a risk of classic cyclicality.
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MMG: Pankaj, we just talked about the softening economy. What are your expectations in terms of portfolio performance if we do go through a bit of an economic downturn?
PG: You have to really think about people’s portfolios in the context of how much cyclicality are they accepting within their portfolios and then also, how are they structuring their portfolios. Meaning, you know, what is the average leverage multiple, what is the average loan to value, and what does the covenant picture look like, as well as what is the cash flow profile of the underlying credits that are in people’s portfolios, i.e., do they have low Capex or high Capex?
Our portfolio, thankfully, we’ve been very focused over the years on minimizing the level of cyclicality that we allow into the portfolio. As such, you know, sectors like auto or energy or construction or retail or restaurants—those are very minimal, minor or nonexistent in our portfolio. So we would anticipate that those would hold up, the overall portfolio would hold up well.
The other thing is for folks who were doing deals at 6 or 7x leverage in structures that were covenant loose or covenant light, where there were no covenants, or if there were, they were very wide. Those deals will likely cycle to a level where they will experience a payment default and/or run out of liquidity well before a lender has a seat at the table to effectuate a restructuring of any sort.
Compare that to the portfolio that we manage where most if not all of that portfolio is more of your traditional, old-fashioned, direct lending type of structure where we’re lending through a leverage multiple of say, three-and-a-half, four, four-and-a-half or five times leverage and structuring these deals with very traditional covenants and traditional structures and definitions to EDITDA such that if there is a softening in the economy, clearly, companies will face a bit of headwind, EBITDA will go down a little bit but again, when you focus on businesses with the recurrence of revenue stream, high margins, high free cash flow, profile low Capex, that downdraft should be manageable, and then, with the appropriate structural protections in place the portfolio should perform with minimal losses or impairment.
MMG: Good market, bad market, everyone does troubled deals. So, Stuart, when you do have some troubled deals in your portfolio, how do you turn them around? And perhaps you can first start by discussing what factors might actually define a deal as troubled.
SA: A deal is typically troubled when it starts running short on cash flow to service its debt. And our first line of defense is, we work with the owners of companies to have them inject liquidity into companies to be able to keep the debt fully serviced and to execute economic turnarounds at those companies, whether those require cost cuts or other changes to how the company operates. In some instances, owners, be they either private equity owners or entrepreneurial owners or family offices either don’t have the cash to support their company, or don’t have the willingness to support their company. In those situations, we’re prepared to step in and restructure those companies, and where necessary, operate those companies.
And the fact that we are a part of a $60 billion asset manager with a lot of private equity expertise gives us a strong position in learning how to put appropriate management teams in place, drive growth strategies and cut costs for companies that need restructuring. But again, we are not loan-to-own, we are not vultures, and wherever possible we work hand in hand with the existing owners of companies to turn those companies around, and I’m glad to tell you we have many success stories both through COVID and through normal economic environments of owners of companies supporting their companies and turning those companies around and then exiting those companies with terrific gains.
MMG: Love to hear it. Pankaj, you touched on this very briefly, but are you able to get covenants done? And if so, what are they?
PG: So maybe we should start with the types of covenants that that that exist in the marketplace, or the types of deals. We really think about it as three types of structures. There is your covenant light transaction where there are no financial covenants or maintenance covenants. In those situations, a lender is really relying upon the quality of the underlying company. But if there is a deterioration in the performance of that business, again their first ability to have a say in the future of that capital structure, that company will come when there’s a payment default, when the company’s unable to pay their interest expense, or their amortization. Those deals typically occur in a market where EBITDA is greater than 100 million. They also do occur in the upper middle market between $50-100 million dollars of EBITDA in some cases. We stay away from those transactions.
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Then there’s a second type of transaction, which is what we call covenant wide or covenant loose. These are structures in which lenders have a covenant and therefore they’re able to report to their investors and their lenders that they have a covenant in the deal, but oftentimes these covenants are set at or greater than the underlying enterprise value of the business to which they’re lending. So, for instance, they may be lending to a company at 5 times leverage that is worth 9 times its EBITDA, and the covenant will be set at 9 ½ or 10 times EBITDA. Therefore the first real trigger, again, in those situations oftentimes occurs upon payment default even before the covenants come into play. Again, we do not do those types of transactions.
Which brings us to what we do focus on, which is your more traditional core middle-market covenant structures. These are traditional structures where if you were lending to a company at, say, 50% of its enterprise value—let’s use easy numbers and say you’re lending at 4x debt-to-EBITDA [to] a business that’s worth 8x. You may have a covenant that starts at six or six-and-a-half-times debt-to-EBITDA, and then has step-downs from there. What this does again is it provides lender protections: If the company deteriorates or performance is not according to plan, we have a seat at the table to work with the company, the management team and the ownership group to ensure that the right actions are being taken to stabilize the business and start to regrow it. Having that covenant protection we believe is paramount to preventing losses and ensuring the protection of our capital.
MMG: To close out the conversation here today, I wanted to talk more about credit structure. Stuart, let’s start with you. What changes are we seeing in credit structure and terms in middle market and lower middle market sponsor transactions?
SA: The main change that you’re seeing right now is that leverage multiples are going up, and that’s despite the fact that interest rates have not come down. So six months or 12 months ago, people were doing deals where the interest coverage ratio, the EBITDA to interest charge was somewhere between 1.8 and 2.2x. We’ve seen that come down fairly dramatically in more recent times, as people are once again doing leverage multiples of five-and-a-half, six, or even more than six-times and when you take out the maintenance Capex that the company has to spend to keep itself operating, the net cash flows of those companies on deals being done in today’s market appeared in many cases to be very thin and we are concerned about that and we know that there are many other lenders that are concerned about that as well.
Leverage multiples are going up, and that’s despite the fact that interest rates have not come down.
MMG: And how about what we’re seeing in terms of credit structure in the sponsor market versus non-sponsor, Pankaj?
PG: I’ll start with the fact that I think both markets are very attractive for their own reasons. In a sponsor transaction you have a good company that’s being bought by a sophisticated sponsor that can add guidance from the management, operations and technology perspective, as well as provide capital support in the event of a downturn. In the non-sponsor market you don’t necessarily have those factors, although oftentimes you do have sophisticated families that own these businesses and have sophisticated and significant resources to support them. But what we are able to do is equalize the level of risk between the non-sponsor and the sponsor markets by having lower leverage profiles in non-sponsor transactions relative to sponsor transactions. And we think that’s generally consistent across the marketplace where, if we’re financing a company or a management team or an entrepreneur directly, oftentimes the market will be a bit more conservative in terms of the amount of leverage afforded to that company relative to if it was being purchased by a private equity sponsor.
Secondly, the structure and terms do differ in terms of covenant profiles. In non-sponsor lending, we find that oftentimes the covenant profiles are appropriately close to levels that the management team predicts that they will perform at and so there’s less cushion before again, you have the opportunity to have a conversation with the company or its management team to again understand how the business is performing.
And then, lastly, in terms of pricing and spreads, there is a difference between the two markets. Sponsors generally are able to command tighter spreads and tighter pricing relative to non-sponsor transactions. They’re able to run more competitive and more efficient financing processes, thereby getting slightly better execution in terms of spread and in terms of pricing.
MMG: Stuart, Pankaj, thank you so much for joining the podcast. You know, as I mentioned earlier, dealmakers always want a crystal ball. We can’t deliver them that, but this has been a really insightful conversation into what could be ahead this year, so thank you both so much.
PG: Thank you, Carolyn.
SA: Thank you so much.
This transcript has been edited and condensed for clarity.
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