(Greenwich, 9/27/2006) My partner Rob Tucker confirmed today there is a wall of money chasing a shrinking pool of deals in the middle market for private equity transactions. Banks, mezzanine lenders, and equity investors are all trying to get money to work. A business that would have sold for 4.5 times trailing 12 month EBITDA, or cash flow, 5 years ago is now trading at 7.5 times. At those prices an equity investor selling the business at the same multiple 5 years from now would earn high teens returns even it the company hits its business plan. Mezzanine lenders would earn 12-14%.
This chart shows Thompson Financial data for average transaction multiples by size of deal, with prices ranging up to 9 times cash flow for over $100 million deals. TAggressive lending is driving the high prices.
Transactions are now being done with total debt levels of almost 5 times cash flow and senior debt over 4 times cash flow. Both numbers are as high or higher than anything we saw at the peak of the last buying binge in 1999 and early 2000. Although there are rumors of credit officers asking questions about companies having a hard time meeeting aggressive plans there is no sign yet of a pullback by lenders.
On Larry Kudlow’s show Tuesday night we had a spirited debate with several guests who were ready to declare a recession. I see no signs of recession yet. But I knnow how to create one if you would like me to do so. Recessions happen when credit markets shift from being cleared by market prices and being cleared by non-price rationing. that happens when there is a sudden deterioration in collateral values for existing loans (as in 1989-92 when land prices fell for the first time since the 1930s) or in the cash flow levels specified in loan documents or when the order goes out from central command (the Treasury or Fed) to stop lending (as in 2001-2004). these conditions create a temporary ‘blackout’ in credit markets during which it is difficult to get credit at any price. We should keep our eye on private equity loans and real estate loans as potential sources of a blackout.
JR
Mr.Rutledge what are best data sources to track credit available to small companies ie asset based loans or revolvers does fed keep track of data.
Mr. Rutledge,
I heard you on the radio yesterday explain that recessions have occurred when banks, under pressure by regulators, essentially stop lending all at once. I wonder if it’s possible that these discrete episodes of simultaneous pullbacks by the banks also correlate with outperformance/underperformance by smallcaps relative to largecaps. Just by looking at interest rates (and other typical variables), I’ve never been able to anticipate the rotation from small to large caps & vise versa. But, given the dependence of small companies on bank loans, I thought these episodes you describe might help understand the long periods of out/under performance by smallcaps.
Dear BamBam,
You are exactly right. More than half of GDP is produced by small companies who do not have access to public markets. They get their working capital from commercial banks and private equity. When the banks shut down, business loans become unavailable at almost any price. Banks turn into loan collectors, instead of lenders. This makes small companies shrink and triggers recessions. The irony is this behavior typically happens during periods when market interest rates (Fed funds, TBills,,,) are falling, like 2001-2004.
Since small companies fell the brunt of the loan blackout it follows that small-cap public companies (who have only episodic access to public markets) are the eye of the hurricane for the stock market. This is, in fact, the logic I have been using to make small-cap vs. large cap investment decisions for some time.
JR