When Gryphon Investors completed a buyout of OB/GYN services provider Ob Hospitalist in July, lenders, led by Antares Capital, provided the company with over 6x leverage across a first lien/second lien structure, according to two sources familiar with situation.
The LBO was then financed through a USD 45m PIK HoldCo note, bumping total leverage up to over 7x, added those sources.
The deal is an example of how lenders and sponsors are finding ways to add leverage in order to win auctions in an increasingly heated middle market. Buysiders are using products subordinated to second lien and mezzanine debt, such as preferred equity or PIK HoldCo notes, to finance deals in a market where enterprise value multiples are well into double digits, four sources said.
The Ob Hospitalist buyout was underwritten on roughly USD 45m in LTM EBITDA 4.5x leverage through first lien, 6.3x through second lien and 7.3x through the HoldCo notes, sources said.
This came on the heels of a hot year in 2016 for healthcare private equity, as USD 36.4bn in deals got executed, according to Bain & Company’s Global Healthcare Private Equity and Corporate M&A Report in 2017. This included emphasis on outsourced businesses as investors shied away from heavily regulated business.
Antares and Gryphon declined to comment on the terms of the deal.
As a broader market trend, use of products such as preferred equity and HoldCo debt can be symptoms of frothy valuations.
“It’s something one tends to see at credit market peaks,” said an executive at a non-regulated lending institution.
Average leverage through subordinated debt on middle market deals was 5.39x in 2Q, and 5.11x through unitranche debt, according to Debtwire Middle Market and Piper Jaffray’s Private Credit Report.
However, in the case of preferred equity tranches, those securities are not considered turns of leverage, even though they are senior to common stock and pay a cash or PIK coupon.
“It’s to comply with leverage guidelines,” a capital markets lawyer said. “It could be internal self-regulation and credit committee issues. A lot of times it’s the sub debt provider (who holds preferred stock).”
Sources said that preferred equity or HoldCo notes are frequently funded by either mezzanine/sub debt-focused funds or a private equity sponsor’s limited partners.
While business development companies (BDCs) may engage in a range of investment strategies – from senior to sub debt, and mature to early-stage companies – generally speaking, they hold loans of privately-held middle market companies. According to Advantage Data, new preferred stock issuance held by BDCs has steadily increased since 3Q16, including a spike in 1Q17 (see chart below)
Furthermore, use of preferred equity or HoldCo notes can increase volatility for the equity sponsors. On the one hand it pushes their common equity further down in the company’s capital structure and increases cost of capital. On the other hand, it also potentially boosts exit returns.
“They’re trying to win a competitive process,” the alternative lending executive said. “Looking at the equation of purchases price vs. exit multiple, it pushes out the junior equity’s internal rate of return curve…effectively net leverage is higher.”
In a buyout illustrative of how high middle market EV multiples can go, Summit Partners’ planned deal for cutting tools provider Harvey Tool values that company at 16x EBITDA, with leverage around 6.5x through subordinated debt.
On the auction front, meanwhile, Ryan Herco Flow Solutions, a pipe and valve distributor, is expected to fetch an 8x-10x EV valuation in a Harris William-run process. Ryan Herco has been a roll-up platform for Greenbriar Equity Group since 2011.
In addition, Harris Williams got engaged by Digital Room to sell the online printing services provider. The company is being marketed on roughly USD 35m in EBITDA with leverage views solidified around 6x or less.