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.

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.

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.

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."

A Short History of the Middle-Market Private Company Debt and Equity World

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.

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.e., 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.

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.

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.

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.

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.

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.

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.

The DebtQuity Zone

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.e., 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.

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.

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.

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&L line more thoroughly.

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.

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.

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.

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.

Lenders as Owners, DebtQuity Looms

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.

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.

Today's Weather

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.

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.

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Footnotes

1 Ken Yager at Morris Anderson & Associates, Ltd. also contributed to this article.