DebtQuity A Perspective on the Current Blur Between Debt and Equity

DebtQuity: this term might either become folklore or part of a new lexicon of deal language
for small- to middle-market private companies. Right now, it is a wake-up call
to the credit world and equity investors alike.
</p><p>Never in recent decades has so much money been available to structure the transfer
of value from one owner to another or to cover operational shortcomings. The
amount of capital currently available is staggering and has resulted in an era
of hyper-liquidity.
</p><p>This situation has placed a new kind of pressure on both lenders and equity
sponsors to place funds and enter deals that may have been avoided in the past
(or had more restrictive covenants). This glut of capital is being poured into
every crevice by lending institutions and equity sponsors, resulting in a blur
between assuming the risk of debt vs. the risk of equity.
</p><p>As investors will note, rational investment decisions are based on what each
investor sees in the market as well as the immense pressure to deploy portfolio
funds. Lenders face a similar situation and have taken some comfort from the
cushion frequently provided by equity-sponsored capital infusions. What has
resulted is that the current market has many over-leveraged deals that mask
underlying operational issues. We now stand at a place not seen before where
debt and sub-debt have eerily taken on the risk of equity—hence, the emergence
of "DebtQuity."
</p><p><b>A Short History of the Middle-Market Private Company Debt and Equity World
</b>
</p><p>Traditionally, small- to medium-sized private companies grew up with bank debt
and shareholder equity often funded by the original owner and those involved
in the business. Fast forward to today: It seems that the recent explosion of
the hedge funds and the resulting "hyper-liquidity" in capital markets
has caused a blur between debt and equity along the lines noted above.
</p><p>The overabundance of funds in the market has put pressure on lenders that would
have followed more traditional financing terms and related due diligence to
place debt in situations where they would have had tougher covenants and higher
pricing on debt. Funds are being layered on by equity sponsors who, in smaller
transactions, often have no involvement/interest in the business other than
financial. On larger transactions, the investment group traditionally demands
a seat on the board and/or management intervention, but is still adding capital
to underperforming debtors. Over-leverage, combined with ignoring the root cause
of why the business is underperforming, has resulted in a potential house of
cards when working capital tightens due to real operational issues or, on the
capital structure side, when economic conditions tighten—<i>i.e.</i>,
a rise in interest rates. As these falsely supported companies begin to unravel,
the decline may end up being so great that, in conjunction with the new bankruptcy
laws, the implosion will result in liquidations where the debt will have a similar
risk to what, in the past, was reserved for equity players.
</p><p>Professionals that deal in lending or equity are aware that the nature of deal
flow and deal terms has changed dramatically. Thirty years ago, standard equity
deals were done by venture capitalists. Leveraged buy-outs ensued as the next
big trend. That led to trouble as highly leveraged deals were structured with
almost no equity content.
</p><p>This problem corrected itself with a multitude of painful restructurings. Leveraged
buyouts were cleaned up through private-equity investors. That was fine, but
the equity still needed more debt than before to get the deals done. A seemingly
novel form of debt was invented, as banks were not able to provide sufficient
debt to satisfy the deal formulas (or debtors couldn't shoulder the traditional-financing
interest loads). The junior unsecured debenture market evolved. Some of it was
mezzanine and some of it was high-yield debt. To be sure, high-yield debt had
been around for a little while by the time the term private equity had come
into existence, but its role in the market was evolving.

</p><p>It was under the growth of private equity that "high yield" came
into its own, which also did not go over so well. It appears that whether you
were in the middle market or the large-cap market, junior unsecured debt was
often falling prey to performance issues, and the debt did not fare well. It
was as if the debt, during its natural life, was akin to equity risk vs. debt
amortization risk due to the instability of cash flow.
</p><p>Similar to golf where it only takes one good shot to keep the adrenaline running,
despite significant losses in various leverage buyouts and a significant amount
of expensive deal restructuring, the private-equity market has re-emerged larger
than ever in recent years. Clearly, this larger market needs more debt, so like
a magician and his hat, the private-equity market discovers another set of tools
and tricks for its needs: second-lien debt and the uni-traunche. While each
presents itself to the market differently, ultimately in a down market each
will act upon the deal recovery dynamics about the same. This article was not
written to explain these products, but suffice to say, they are the same debt
structures wearing new clothes.
</p><p>What is clear is that capital has reinvented itself. Nevertheless, while legal
documents change and stake out individual claims to priority, the principles
of sound business have not changed and still apply to cash flow generated by
operations. Deals are only successful based on the underlying cash flow generated
by solid business operations, hence the "EBITDA" calculations and
covenants included in leveraged deals. EBITDA goes up and down and owes no allegiance
to the dealmakers and business buyers, rather only to the underlying operations.
</p><p> In the history of dealmaking, a yardstick exists for measuring good debt.
If your deal debt is below this line (measured as a multiple of EBITDA), and
appropriate due diligence has been performed on all aspects of the company,
you are likely to have a solid deal. Above that line, it is likely that restructuring
pressure will build. Restructuring means that someone has to assume repayment
risk that, without operational improvements, may become very costly. There is
a zone within these deals that fits the term "DebtQuity." The definition
of this zone is that point where debt becomes undercompensated for its risk—a
zone that arguably, on an overall basis, has been entered into in the current
market of private middle market companies.
</p><p><b>The DebtQuity Zone </b>
</p><p>DebtQuity might just be viewed as yet another brief cliché. But given
what most professionals, whether practitioners, lenders or equity sponsors,
are discussing at the watercoolers these days (<i>i.e.</i>, the "hyper-liquidity"
due to the massive amounts of debt and equity funds available to debtors), it
appears that DebtQuity is real and shouldn't be easily dismissed.
</p><p>What does this mean in the current marketplace, and what is to be done about
it? In the market it means that a house of cards has developed. Combined with
onerous changes to the Bankruptcy Code, this will mean an exponential growth
in liquidations of debtors unwilling to address operational issues (or seek
outside assistance) before it is simply too late to work on a pre-pack or full
chapter 11.
</p><p>To help avoid this dilemma, due diligence is more important then ever. A solid
look at management and improving operations becomes even more important than
in more conventional times. Infused cash may help short-term working capital,
but it is extremely important that the debtor, lender and equity sponsor work
together to put invested funds to good use by fully understanding the business
and its underlying operating model, and looking to the medium and longer term.
Whether done in-house or through the use of outside professionals, in this current
economy this step has taken on a whole new level. Standard ratio analysis and
z-scores are no longer enough. Constant communication with management and a
hands-on approach to understanding current and projected cash flow will be keys
to avoiding the pitfalls of DebtQuity.
</p><p>Cash flow is the special product of internal and external forces to a company.
The ebb and flow of that cash is often measured by buyers in their due diligence.
When cash flow is measured over time and across industries and company size,
a norm begins to emerge about the various forces that cause an impact. Almost
all of these variations or patterns have very little to do with the amount of
debt a company is carrying (except in debt service cash payments) or whether
the lending market is being aggressive. Rather, cash flow is more directly impacted
by the decisions of management, employee relations, customers and suppliers.
The names may change over time, but the impact of such things as attrition,
concentration, depreciation and competition play out regularly with companies.
This is why the industry looks explicitly at EBITDA as a measure of a company's
value. However, with the thought of DebtQuity, perhaps it is time to look below
this P&amp;L line more thoroughly.
</p><p>The power of modern computers and more experienced professionals in the lending
and equity communities has resulted in more credible information that can better
assess a company's value versus the same information even a decade ago. But
there is a limit to these values. The competition to place debt and/or equity
still results in amazing deals coming to fruition that would not have happened
even five years ago. The risk of placing debt by a lender has not been mitigated
by the presence of liquidity in the equity market. Rather, risk has increased
as the space between debt and equity has narrowed.
</p><p>The zone of DebtQuity remains the area that, over time, says this is the internal
risk based on a company's cash flow. If you look at the cash over high and low
periods for a company and similar risk for other businesses, you begin to see
that the amount of debt a company can bear remains tied to a ceiling. EBITDA,
we recognize, changes over time. Hopefully, with strong management and sound
business decisions, it increases through prudent and organic efforts or by growth
through well-thought-out acquisitions.
</p><p>As operational change is implemented by the debtor, the DebtQuity zone again
changes. But the basket of risks that a debtor presents is measured over time.
Short of developing a strategy of trading in and out of a company on a daily
basis, which few leverage investors can do, investors must determine a zone
that satisfies the risk they can tolerate, while continuing to deal with the
pressure to place funds.

</p><p>In summary, debt should not correlate with market liquidity; debt correlates
with EBITDA over time. Proper leverage remains one of the best reward and discipline
tools the financial markets have to offer. Reaching the DebtQuity zone not only
sets up payment risk (just considering a historical perspective), but over-leverage
also has an insidious way of tearing into operational efficiency, depressing
cash flow beyond the normal fluctuations in EBITDA.
</p><p><b>Lenders as Owners, DebtQuity Looms </b>
</p><p>To take this one step further, if you are a lender and have crossed into the
DebtQuity zone, then, by definition, you have just entered into risk associated
with being an equity-holder. Many debt placements over the past three years
qualify for this unwanted status.
</p><p>The equity in the deal is not a cushion beneath you as much as it has become
"on par" from a risk perspective. The deal will need to be carefully
reviewed through a pragmatic group approach with the lender, equity sponsor
and debtor (in conjunction with being cognizant of the amended bankruptcy laws)
in order to ensure that enterprise value is maximized. All these constituents
must maintain close communication and recognize when declining business operations
are becoming a threat to debt repayment and/or equity position. Those in denial
will suffer faster than ever before in these over-leveraged situations. If a
lender and investor cannot have a rational conversation early on when faced
with challenges, the conversation later will only be darker and solutions only
that much less palatable/beneficial to all parties.
</p><p><b>Today's Weather </b>
</p><p>Debt multiples are at very high levels, and interest rates are historically
low. Companies that have been supported via the "hyper-liquidity"
in the current market may ultimately fail without addressing the underlying
operational issue, even if there is not an economic slide in the general economy
and/or diminished liquidity. These factors will only exacerbate the current
DebtQuity situation.
</p><p>Leveraged capital and bank debt are very important to the success of many of
ventures. However, crossing into the DebtQuity zone, where the risks of debt
take on the risk level of equity in middle-market underperforming companies,
will lead to failures and disappointment for both equity sponsors and lenders
alike.
</p><hr>
<h3>Footnotes</h3>
<p> 1 Ken Yager at Morris Anderson &amp; Associates, Ltd. also contributed to
this article.
</p>