While 2022 was a challenging year for many index funds and most everyone’s 401(k), private market buyouts and ESOP transactions remained relatively robust, in terms of both valuation and transaction volume. In this month’s episode, Chris and Chase sit down to unpack how, even amid rising interest rates and the prospect of a recession, business owners were still able to leverage ESOPs to achieve their succession goals, and what dynamics lay ahead for owners weighing a sale in 2023.
Transcript
Chase:
Hello and welcome back to What’s Next, hosted by Acuity Advisors, the show where we help middle-market business owners understand and monetize the value of what they’ve built. I’m Chase Hoover and I’m back here today with Chris Kramer. Good morning, Chris.
Chris:
Good morning, Chase.
Chase:
We’re in the midst of the run-up to the year-end, which for anybody in the ESOP or other kind of ownership transition business is a pretty busy time of year. We thought we would just jump on and record a quick episode to talk about what we’re seeing in the overall economy, but certainly the deal environment and what we’re working on in the run-up to year-end. Chris, what stands out to you, just off the top of your head, right off the bat?
Chris:
I think it’s a combination of really two primary factors. One is the rising interest rate climate that has really happened over the last two or three months in a pretty rapid fashion. Also, the overhang of the potential for a recession next year, which combined with the interest rate environment is causing banks, trustees, and others to be a little bit more cautious about what they’re willing to pay and how these transactions are being structured than perhaps they ordinarily would be.
Chase:
Let’s stop and talk first about that first comment you made about rising interest rates. Obviously, that dominates a lot of news headlines. A ton of the overall financial system is very laser-focused on what the Fed is doing and what banks are doing. But, particularly in ESOP transactions, what are some of the second or third-order consequences apart from just something as simple as, let’s say, the rate of interest on your bank loan is a couple of hundred basis points higher?
Chris:
There are a few things. Number one, as you know, ESOPs are essentially cash-flow-driven transactions. Meaning the ability to actually make the numbers work and to stay within bank covenants and to be able to service the debt, etc, is really cash-flow-driven because there isn’t a source of capital at closing other than a bank loan as opposed to, let’s say, a third-party transaction. So, that’s one thing.
The second is really around valuation, where rising interest rates really significantly impact and negatively impact valuations. You have this convergence of the cash flows are under pressure because the interest rates are higher. At the same time, the valuations are compressed or at least going to be impacted by interest rates, so you have a push and a pull between the seller and the trustee, and of course, the bank.
Chase:
With valuations being somewhat negatively impacted by the borrowing rates and then the bank, of course, and the sellers, in turn, looking for a higher rate of interest, you have this, to use your term, “push-and-pull dynamic,” where the seller doesn’t want to give on value because in their minds, the results are still strong. There’s still plenty of backlog, particularly when we talk about a contractor. But really in a lot of segments and industries, the performance is still there, even with the recession on the horizon. So there’s not an inclination on the part of sellers to concede that the valuation may need to come down. But, at the same time, there’s certainly no concession on the part of banks that they’re willing to lend at below-market interest rates. So there are only a few areas where the structure can give and still pencil at the end of the day in terms of the debt service.
One of those is that you have longer seller note terms just in order for the coverage to make sense. A note that may have taken seven or eight years to pay off the subordinated debt piece might now take ten. Another thing we are seeing pretty regularly is PIK interest, which we’ll get to a little bit later in the episode. I want to focus just for a moment on this whole notion of not having valuations contract at all because what we’re seeing in the public markets is obviously a frequent point of conversation with trustees.
You look out at whether it’s a broad index like the S&P or the NASDAQ, in particular this year, or any specific company, a lot of their valuations are off 10 or 15% over the course of the year. In the private markets, which is of course what we’re talking about, that hasn’t quite happened to the same extent so far this year for third-part M&A. I think that’s informing the fact that a lot of these sellers are saying, “Hey, look, in the M&A market, we’re still getting seven times EBITDA, sometimes eight, nine times EBITDA.” But, then on the other side, you have the public markets down a fair bit more than that.
Chris:
Yes. Part of that is because whether it’s rising interest rates, and of course, rapidly rising, which really over the last three months, we’ve seen roughly a 300 basis point increase. That’s a pretty rapid rise, although a lot of that was expected over time. Whether it’s that or inflation, these things take a while to manifest. We all see the shock of a higher grocery bill, or up until recently, higher gas prices, or a reset on our mortgage. The first month, the second month, the third month, we can sort of handle it. After a year or two, the impact really starts to be felt.
I think you see the public markets really reacting more to the interest rate climate in the short term than the private markets have accepted. But, make no mistake, over the next year or two, assuming rates and inflation stay at these elevated levels, you’re going to see compression. In fact, you’re already seeing it in the market in the last three or four days. It’s sort of a slow burn at this point.
Chase:
I think that’s fair. Obviously, there are lots of things that play in public markets that don’t get introduced in private markets, like selling pressure from ETFs and institutional buyers. It’s important to note that particularly in an ESOP transaction, a lot of M&A deals, you can still see that seven, eight times multiple, that full valuation because the sources of capital are materially different. You’ve got a buyer, presumably, that’s going to bring some amount of equity into the deal. They may be tapping a senior lender or a lender group for a couple of turns of EBITDA and maybe even a mezzanine lender for another turn or turn and a half.
Other than that, there’s some amount of equity in the deal, and so on that mezz piece, let’s say the mezzanine loan that is behind the bank, they can pay a 10, 11, 12, 14, 15% coupon on that debt because it’s only a turn or a turn and a half. But, in an ESOP transaction, it’s all debt. So if you have a seller note that’s the only source of capital other than the bank in a deal, bringing that in at a full mezzanine rate like that 10, 12, 15%, you’re going to have to find some other form or structure for that rate of return to be provided, which is where two primary sources come in. One is PIK, or payment-in-kind interest, which we’ll define here in a second, and the other is warrants. I think the former is more frequently seen in an effort to placate what the bank needs to get comfortable, whereas the latter is more a hallmark of ESOP transactions, and actually sometimes highly desired by the sellers, which can help bridge that gap.
Chris:
Yes, and I’m not sure, it’s only the sellers. The point of a warrant really is to alleviate the cash flow burden on the company. If the company’s cash flows could support and there was enough flexibility to have a stated rate at, let’s say, 11, 12%, then we would do those deals. But, if you look at how the numbers shake out unless the company is going to grow incredibly rapidly, most of the time you can’t make that pencil, so what do you? You defer that payment of the interest either in PIK, but more to the point in this example, in the form of warrants, and the seller’s willing to do that in exchange for potentially even additional upside.
At the end of the day, when you don’t have an outside source of capital other then a bank that’s loaning one and a half or maybe two times EBITDA in this climate, obviously sometimes higher, but generally, those are what we’re seeing, the stated interest has to be lower, so that the company has some flexibility to be able to reinvest in the company and maintain operations.
Chase:
One final question before we pivot over to the other point that you highlighted at the top here, which is that lenders, particularly when they’re looking at let’s say more recession-sensitive businesses or industries, are maybe getting a little more skittish. On that warrant piece, you talk about an all-in rate of return for a seller and the mutual benefits of warrants. What are you seeing in terms of a trustee’s level of comfort that maybe a couple of years ago the market rate of return on a note would be 10, 11, 12%? To your point earlier, we’ve seen benchmark rates like prime, for example, basically double or go up 300 or so basis points in the last few months. Are trustees getting comfortable providing all-in rates of return that are, let’s say, commensurately higher when a portion of that has to come in the form of more warrants and more dilution as a result?
Chris:
The answer is yes, but with the caveat of the last point you made relative to dilution. This is the concept that at some point the pie is fixed and the question is how does it get split up? Some of it goes to the seller, some of it goes to the current pay on the interest, and some of it goes on the warrant piece later on. In other words, because the ESOP doesn’t start off with any capital, it has to be willing to finance the terms of the transaction and the trustee agrees with that. The problem is if the rates come up too high, then what you have is more dilution going out of the trust, if you will, in years 7, 8, 9, and 10.
What we’re seeing at least on a few transactions is that the trustees will pay a higher rate, but they’ll cap the dilution. In essence, they’re capping the rate because the likelihood… Now, this is all in a model, so nobody knows what’s going to happen for 7, 8, or 9 years, but in the model it would say, for example, we’re going to have a 12.5% all-in rate of return. If the stated rate, let’s say, is seven, right, which is not unrealistic in this climate, then you have 5.5% left over that has to be counted for in the form of warrants. If that ends up with a 25% dilution to the ESOP, the trustee’s going to say, “No, we’re going to cap it at, let’s say, 20%,” in many cases. What that really says is that the extra 5.5 is more like five or 4.8 or something, so there’s again this sort of tension between the rates and the value and the term and the amount of warrants versus the stated rate and the cash flows and all those things have to get worked out between the parties to make the deal happen.
Chase:
What it sounds like we’re all saying in one way or another right now is the topography or the frequently observed mix or level of these things in deals is shifting beneath our feet right now, right? I mean, that’s the high, 10,000-foot view way of saying it is whereas things typically shook out in a fairly predictable or at least somewhat predictable level in terms of rate of return and capital sources and what have you, now is much less known going into a deal because these things take time. The ESOP transaction typically from the initial providing data to a trustee and beginning the negotiation process all the way through closing can be a few months at least, sometimes much longer, and at the rate with which interest rates and the overall economic climate are changing right now, that can mean a pretty meaningfully different thing when at the outset of a process versus what ultimately gets negotiated.
To that point, shifting over to the bank-focused side of this, we mentioned at the beginning of this podcast that right now, as folks are talking more and more about the likelihood of recession, whether you think it’s in the second quarter of 2023, whether we’re already in one, or whether it’s not going to start until 2024, obviously the question becomes, “Who’s going to be most impacted by this and why?” One of the areas that I think most people would agree are likeliest to underperform in a recession are the more cyclical businesses and one of those big segments is contractors. It’s heavily geographically dependent. Some areas are going to do better than others, some residential versus commercial, whether you’re focused on this or that. Certainly, a broad mix is to be expected. But, what we have seen for sure is that they are getting a little bit tighter with the purse strings when it comes to lending into new contractor deals. Is that fair to say?
Chris:
Yes, it’s fair to say, and they’re also laser-focused on the current performance as some kind of an indicator for any future pullback. In other words, looking at the backlog, looking at month-over-month WIP schedules, and looking at month-over-month performance to try to get some indication as to whether there’s anything they should be aware of in terms of future performance.
That said, we’re also seeing them come off of initial commitments to the extent that the company doesn’t have a straight path to ongoing performance, so that would say that instead of lending 1.8 or 2 times EBITDA in a deal, they’re really more comfortable at 1.5 or putting some restrictions on the payment of seller interest, where we’ve had a bank actually impose a requirement that a portion gets paid in kind, or PIK, because again, with the rising interest rates, the covenants don’t change that much, so all of a sudden, if you’re paying 7% on a senior loan instead of 5, you’re butting up against that cash flow covenant, and it’s happening pretty quickly. The banks are definitely more cautious, getting more stringent on covenants and coverages and writing in language where, in fact, in this one transaction, the bank is actually going to have to approve the payment of the seller interest. In other words, they’re going to do the assessment as to whether we’re within covenant or not and then ultimately say, “You can pay X dollars against the seller note.” That’s a shift from what we’ve seen in the recent past.
Chase:
It’s a much harder market, much more of a lender’s market in terms of dictating where they’re willing to lend into these transactions. Do you think that’s reasonable? Or what’s your take on that in light of some of these contractors having still record-high backlogs? I can imagine a scenario where you have a company that wants to borrow 1.5 or 2 times its EBITDA and if they’re even able to generate a less-than-average margin on what’s already in the backlog, they’ll have what they need to repay that loan two or three times over and yet the bank is still saying, “Well, that’s all we’re willing to lend. Oh, by the way, we have these other three or four covenants that we want to introduce to reduce our risk.”
Chris:
I had that exact conversation with a bank recently, and unfortunately, with all due respect to my banker friends, the banks are in somewhat of a box. They are regulated and they have their own internal processes to follow as well as guidelines and requirements. They’re not going to be as creative as a third-party buyer or as maybe a sell-side advisor tries to be on an ESOP to try to accommodate, so don’t fault the banks per se, but they definitely don’t have either the ability or the desire to really deeply understand and analyze and see a case-by-case situation in terms of what they’re willing to do.
They’re going to have more of a formula approach, and I think some of that’s, again, the regulation. Some of that is, look, they do have to make sure that they get repaid. When you have the head of several major banks coming right out and saying, “We’re going to have a recession,” the rest of them follow suit.
I use the old IBM analogy where back in the ’50s and ’60s, the old adage was no one ever got fired from hiring IBM. Whether they were the best or not. No banker is going to get fired by not making the loan as much as they got to get repaid. If a bank makes a loan that they don’t get repaid on, they have to make many dozens of loans that they do get repaid on, so they are going to be naturally more conservative and risk-averse and want to see the clear path to getting repaid.
Chase:
I think that as we move forward, especially into early 2023, if we do see recessionary deterioration in underlying performance at a company level per se, I think it’s important for sellers to recognize that even if they’re bucking that trend and their performance is robust, hopefully, you’ve got the kind of relationship with either a lender that you already work with or lenders that you shop the financing to that they would see through that risk calculus that their parent organization is encouraging or requiring them to make and say, “This is a great business. It is performing well.”
The reality is that they are sometimes at the mercy of the risk tolerance of their overall organization and maybe they have capital requirements that there are already too many contractor loans on their balance sheet and they’re not adequately capitalized, so they want to save their balance sheet for those clients. It’s just going to be a harder market for contractors. I think a much harder market than it’s been in the last three or four years when this has been a pretty strong environment with, of course, the exception of COVID.
Chris:
In closing, what can we do? What can sellers do? One thing I would remind sellers of is the reason that you’re generally looking for a bank loan is to fund the purchase of 1042 notes, meaning if you’re not taking 1042, there’s less reason to go to a bank and borrow a significant amount of money. If you are taking 1042, there’s always the option if you have personal liquidity to use some of that liquidity to either facilitate a longer period of time that you can shop the bank, deal with the bank, or negotiate with the bank, but also that you could lower the amount of the bank loan that you actually take down if you’re willing to put some of your personal assets up as part of the financing of the notes.
The other option, of course, which nobody wants to talk about is the sellers can take lower purchase prices if that’s going to alleviate some of the compression on some of the covenant coverage and cash flows, etc. But, other than that, other solutions could be partial ESOPs, which we’ve seen where if there’s not a need to necessarily sell a hundred percent, it has some of its own complications, especially around 1042. Each circumstance is a bit different.
Chase:
I think about alternatives to your traditional senior lender. I think there’s still the demand for a lot of that that’s not yet met by supply. I know there are a few names out there and I’m sure there are lots that I don’t know about, but there are alternative sources of either, if not senior debt, structured debt that can come in and supplement if the bank’s going to be a bit lighter than expected and there’s that need for additional liquidity. My guess is that in this market that’s going to become a theme that we see going into 2023 where there’s a need that gets filled by lenders that are more alternative to the traditional banks.
Chris:
With that, Chase, I’ll let you close us out and launch us into 2023.
Chase:
To our listeners this year, we appreciate you chiming in or listening to us chime in, rather. We hope that we’re able to bring you many more episodes and keep track of what happens in 2023 in real-time, so stay tuned. Looking forward to the new year with y’all. Take care.
Now for the fine print. This podcast is for general informational purposes only. It does not create an advisor-client relationship between Acuity Advisors and the listener or reader and is not intended as advice for a specific situation. Thank you again everyone for a wonderful year. We appreciate you tuning in and we look forward to seeing you next year. Happy Holidays and Happy New Year!