By Randy Schwimmer
I’ve discussed at length the development of revolving credit facilities. Corporate borrowers and private equity sponsors have continued to utilise this tool to maximise flexibility for acquisitions, dividend recaps and working capital. But during 2015 we’ve noted the increasing popularity of another weapon in an issuer’s financing arsenal: namely, the delayed-draw term loan (DDTL).
As their name implies, these loans incorporate the draw feature of a revolver as well as the term out of the standard institutional tranche. Decades ago, commercial lenders offered them to borrowers with extensive equipment financing needs. Because of the long-term nature of those assets, a line of credit was not the best match-funded solution. And term loans were expensive for borrowers if they didn’t need all the capital at once.
Fast forward to today: the delayed draw is ideal for sponsors whose investment thesis involves a series of add-on acquisitions (which is just about all of them in the present climate).
It’s worth exploring what’s driving M&A activity among the private equity community. For one thing, prices are at lofty levels. According to Thomson Reuters, the average purchase price multiple of ebitda for large middle market companies is 10 times. To make returns work for arguably lower exit multiples down the road, PE buyers target small competitors of these platform companies at more modest multiples. Besides the obvious strategic advantages, buying these companies has the effect of lowering the overall multiple of the original purchase.
Scale is on the minds of managers headed into an uncertain environment. Large companies can weather economic downturns, and they are the quickest way to boost ebitda.
In conversations with sponsor clients, the virtues of delayed-draw term loans are clear. “We really like to keep as much dry powder as possible on hand for acquisitions,” reported one managing partner. Another agreed: “We try to get them in all our deals. Whether we use them or not, they’re a cheap option.”
On the other hand, a third partner extolled the benefits of revolving credits. “I’ve been surprised how many investment banks are throwing big RCs into proposals. I’d rather have a five-year revolver than an 18-month draw down.”
That sentiment is driving longer draw periods in delayed-draw loans. A decade ago, these were generally one year. Today draw periods stretch to three years, with the final maturity matching that of the associated term loan tranche (typically six or seven years).
Like revolvers, delayed-draw loans carry fees on the unused portion of the facilities. These “ticking fees” start at 1%. This contrasts with commitment fees on revolvers of 50bp. Drawn DDTL costs mirror term loan spreads. They differ from revolving credits in that once repayments are made they cannot be re-borrowed.
Delayed-draw term loans are lender-friendly. Unlike revolvers, which are generally unfunded, delayed-draw term loans fund over time, with the unfunded portion eventually reduced to zero. That’s good news for non-bank providers, which have struggled to compete with banks in offering revolvers.
The proliferation of the delayed draw is another example of how private equity sponsors are adapting to the new reality of heightened competition, and how lenders are creatively meeting those needs.
Randy Schwimmer is senior managing director and head of origination and capital markets at Churchill Asset Management, a credit asset management firm affiliated with TIAA-CREF Asset Management. He is also founder and publisher of The Lead Left (theleadleft.com), a weekly newsletter about trends and deals in the capital markets.
This column first appeared in the weekly newsletter of Creditflux, a leading global information source for the credit trading and investment market.