Shifting sands in lower mid-market MBO financing

After a hesitant stop-start as the pandemic impacted the UK economy, deal appetite for private equity backed management buyouts quickly sprang back into life last summer and has continued to grow.

Of course, accepting private equity investment in many cases means introducing significant third-party debt to the balance sheet, often for the first time in the company’s life and usually at, or in the twelve months following, investment. Using leverage to drive deal returns for sponsor and management shareholders alike is a well-trodden path, but the shape and size of those debt packages is constantly evolving.

As in 2008, the dislocation of credit markets in the wake of the pandemic has once again reshaped borrower options for buyout leverage, and nowhere more so than in the £1-5m EBITDA lower mid-market segment. Traditionally still largely the domain of mainstream lenders, the avalanche of CBILS applications swamped bank lending teams in 2020, leaving access strictly for existing customers only.

Private credit, as it has done for nearly a decade now in the larger deals market, stepped into the gap with many funds reducing their minimum business size thresholds to be relevant in the lower mid-market. Offering reduced amortisation, longer maturities, higher leverage and most importantly over the last 12 months, strong conviction with faster deal execution, the swing to private credit in this segment was striking in 2020. However, as the pressure of government loan schemes diminishes there are signs that the Banks are returning  to the new deals track in 2021, a recent example being the completion of Horizon Capital’s MBO of The Marketing Practice in April.

For a long time the staple of conservative SME lending, the pandemic has also allowed asset-based lending (ABL) to demonstrate its effectiveness in the racier world of leverage buyout financing. Where increased uncertainty has dampened the appetite of cash-flow lenders for certain sectors, releasing funding against the secure value of invoices, stock and PPE has enabled deals to continue to be done.

Layering a reduced strip of cash-flow lending behind a bigger ABL line, either from the same lender or another, is also providing an effective buyout financing structure when the asset base runs short. Such a strategy was used effectively by HMT in the MBO of Wheelwright Ltd, a leading UK wheels and automotive aftermarket wholesaler supported by Arbuthnot Commercial ABL and Caple International.

Despite this desire to do deals, surely a recession of the likes not seen for 314 years would show the high-water mark for leverage appetite in the buyout market? Not so this time around as government support and low interest rates have suppressed credit losses, which alongside deep reserves of fund liquidity is driving the continued confidence to lend. However as inflationary pressures grow and fiscal support is withdrawn, we may well see interest rates rise and delayed credit stress begin to materialise this year, reshaping the credit cycle yet again.

With more optionality than ever for buyout financing, ensuring the correct approach to debt structuring at the outset is vital for management to deliver the growth plan once the dust has settled on their newly minted private equity partnership.

If you’re contemplating an MBO this year and would like to discuss financing options, please do get in touch with our team on 01491 579740.

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