Proceed with caution — and a little creativity. 

That’s the tip-off for 2023. In this episode, Geoff Cockrell, host of The Banker's Corner, sits down with Bob Bartell, Managing Director and President of Kroll Corporate Finance and CEO of Kroll Securities, LLC. 

Together, Bob and Geoff delve into a topic that has been at the forefront of private equity for a few months now: tightening credit. Given his position at Kroll and experience in a broad array of corporate finance advisory engagements, Bob provides an apt commentary on the current climate, including the impact on healthcare business.

The two also discuss market trends and pauses they’ve seen in 2023 so far, and the creative ways lenders and private equity professionals have been able to think outside the box. 

“Until the owners of these businesses — many of them are private-equity-backed mid-market, private equity sponsors — see an opening in the credit markets, there's a pause,” says Bob, who goes on to explain why and how this pause affects different levels of the market.

Tune in to hear about the outlook for the rest of 2023 and the creative ways professionals are dealing with workarounds and earnouts in this strange market climate.

Featured Guest

Name: Bob Bartell

What he does: Bob Bartell, CFA, is the Managing Director and President of Kroll Corporate Finance and CEO of Kroll Securities, LLC. He’s also a FINRA registered broker/dealer. He specializes in a variety of corporate finance advisory engagements, including fairness opinions, solvency opinions, M&A advisory, financial restructurings, shareholder disputes, and more. 

Organization: Kroll

Connect: LinkedIn

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This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.

This is The Banker's Corner, a McGuire Woods series exploring investment trends, solutions and business issues relevant in today's private equity and finance industry. Tune in with McGuire Woods' partner Geoff Cockrell as he and specialists share real world insight to help enhance your knowledge.

Welcome to another episode of The Corner series. I'm Geoff Cockrell, your host. I'm a partner here at McGuire Woods where I spend all of my time on healthcare private equity investing. Here in The Corner series, we try to bring together thought leaders and deal makers M&A market, and we talk about current trends and some of the impact of those trends on healthcare investing. Today, I'm thrilled to be joined by Bob Bartell. He's the Global Head of Corporate Finance at Kroll. Bob, before we jump into some questions, if you could introduce yourself and Kroll a little bit for our audience.

Thank you, Geoff. So, Kroll is a world leader in risk and financial advisory solutions. We have had a mission for many years in helping measure and monitor and protect shareholder value, whether that is through M&A transactions, business valuations, pre and post-incident cybersecurity, as well as bankruptcy administration.

Bob, maybe to start the conversation, one topic that has been forefront for several months has been the difficulty of availability of credit, the cost of credit. And it just ripples through a number of elements of M&A transactions. Maybe starting at a high level, what kind of impact are you seeing of this tightening of credit?

Sure. So, this 2023 has been quite interesting, challenging for many businesses and many advisors. There are a couple different areas that I think have been impacted within the healthcare business. The first is with skyrocketing interest rates. We've seen some of the real estate Propco investors have trouble getting loans from banks. As you have seen for several years, there's just been a proliferation of many healthcare services businesses that we're able to secure very attractive financing to expand. And for the time being, that is on pause as many of the lenders are just dealing with their real estate portfolios unrelated to healthcare. So, even if it has nothing to do with some of the vibrant and robust healthcare businesses, many healthcare services providers that need a physical location, they've been in a timeout position in most of 2023, given the lack of availability in real estate lending, and the lender's concern of the credit worthiness and solvency of the tenant and the lessee.

The second area is one in with respect to growth companies that perhaps are cashflow negative, supporting their growth and expansion, or more earlier stage businesses like biotech and biopharma. Going back two to three years ago with an open IPO market, we all were seeing even large institutional investors and hedge funds back these businesses in a portfolio approach. They knew some would fail, but the winners would be massive wins. And in this current moment, that market in terms of series D, E, F, as an example, is also in a timeout mode just given the lack of exit strategies. And also, many investors, lenders, equity investors are very cautious at the current moment to support any companies which are cashflow negative. So, it's a little bit of a sign of the times. It's like taking an umbrella away when it is raining and giving someone an umbrella when it's sunny out.

The third would be the strain on the consumer. Starting about a year ago, we saw major increases in petrol and gasoline prices. That has corrected itself. But in the last six months, we've seen increases in interest rates, which we all understand to offset the inflationary environment. But that has impacted the consumer. We all know what it now costs to buy a home. What some of the people who have to finance some of their short-term deficits through credit card payments. Many healthcare services providers, at this moment, are experiencing a deterioration in their receivable portfolio and a stretching of day's collection. So, consumers are tapped out. They know they have a duty and an obligation to make a payment that isn't covered by insurance.

However, it is unquestionable how the cost of debt has made most everyone, from the patient, to the operating company, to the lenders take notice of the stretching of receivables and some apparent deterioration in the portfolio quality. So overall, it is right now just a little bit of the glass half empty, a risk off environment, and it's not cheap to borrow money if you can find it. But it's going from the portfolios of private equity companies, all the way to physician owned dental and center practices, as an example. So, it's a very challenging environment as we sit here approaching the middle of the second quarter of 2023.

Yeah. And it's those effects are not evenly dispersed. There's lots of conversations on the topic that you're just describing of what's the payer mix of a particular provider business. If you're 80-90% government reimbursement, then that takes pressure off of some of those dynamics. But obviously, as you become more consumer paying and some businesses are very heavy consumer paying, those impacts get felt more acutely. Maybe bouncing back to your comment on availability, it's also been interesting to see the different sources of credit getting constrained. I was having a conversation couple weeks ago with a friend of mine who runs a private credit fund. And he was saying that in a typical year, a big chunk of their dry powder for lending comes from what he would describe as runoff, meaning a loan has been paid off, refinanced. But in some form or other, the money comes back to them. And then they can use that to make other loans.

And he was saying, In a typical year, for example, 2021, their runoff would be around 50%. So, half of their portfolios coming back to them to be reinvested. In 2022, it was 12. So, their own kind of sources of capital were further constrained by those market dynamics. It creates a bit of a perfect storm. You've got private credit who's not getting runoff from deals, which then constricts their dry powder. You've got bank lenders that have their own issues that have been highly publicized and are feeling the strain of real estate markets. All of these things are pinching credit at the same time.

That's an excellent point. And I do think that maybe it's coming into focus at this moment that, I wouldn't say people took it for granted, but in terms of the loans staying on the books, it doesn't mean that the majority or super majority of these borrowers are facing financial trouble, or many of them are not even close to having a liquidity issue. However, with the pause in the transaction market, pretty much 90% decline in IPOs. But even as an example within both private companies and private equity backed businesses in the healthcare sector and other industries, the declining exits, namely things like M&A trades and sales has pretty much come to a halt. So, the lenders are sitting on loans that they may be performing, but they're not being repaid to redeploy capital to the next opportunity. So, there absolutely is a stalemate of just everyone is taking a rest right now and has the pause button on.

But the velocity of M&A that the world saw in particular in the United States in 2021 and for the majority of 2022 looks very different in the first four months of 2023. So, that is a fascinating statistic. And I do think that it isn't so much a sign of financially distressed borrowers not being able to repay their loans. It's often a lack of an M&A market that has the owners of these businesses in a timeout position. There are also a number of situations I'm aware of where the credit agreements require full repayment of all the debt in a change of control. But many borrowers at this point that took out credit in the second half of 2020-21 and early 22, many of them have leverage ratios that are unreasonable in today's market, and they also have covenant packages or lack thereof which are also not going to be market today.

So, until the owners of these businesses, many of them are private equity backed, mid-market private equity sponsors, see an opening in the credit markets, there's a pause. And that pause is also due to new borrowers won't be able to access the same amount of leverage, and they won't be able to attain the interest rate levels that were seen 18 to 24 months ago. In particular, some of the covenants are much stricter in a return to a rational market. Perhaps this is just a return to rationalization. But in the meantime, it just is, the risk-off pause button is on.

It's also interesting that it's not for a lack of demand of people wanting to do these things, and that demand, the market can also respond to. There's a interesting article a couple days ago in the Wall Street Journal that was talking about upmarket big private equity funds that are seeing an opportunity to expand their exposure and investment into private credit to backfill some of those constrained markets and do a lot more private credit investing. They articulated it as a golden opportunity for that sort of investing. So, even if the glass is half empty, the market finds a way to pour some water back into that glass.

Absolutely. It's an interesting moment because I think many people, they're still cautiously optimistic. But I do think that in the past month, there's been a wider acceptance that the turnaround is less likely going to be seen in the second half of 2023. No one as a crystal ball, I certainly do not. But if I were to remember some of the questions I asked my colleagues, my clients, my just network of investors, lenders, private equity professionals, there was a little bit more confidence three months ago, in the second half of 2023, that has seemed to decrease recently just with all the factors we're still seeing. And mixed signals all over the board with the data that's being reported on the economy, is inflation under control or not, and what are the next steps? But most folks don't think interest rates are going to be coming down in 2023. And if they do, it's also an admission, not just that inflation may be under control, but that we're really facing serious headwinds. And there's no question, the recession is here and now, and maybe deeper than what was projected at the beginning of the year.

Bob, if doing a five times EBITDA credit supported acquisition is harder to execute, what workarounds are you seeing buyers employ?

The one thing that has come back that has been around for decades, but probably went away for the last 10 years, is that many buyers and sellers are now more open to talk about performance incentives such as earnouts as part of a deal consideration. No seller is not under forced pressure to sell is going to sell at a discount. Fair value changes, and it changes rapidly, and can be profound in a three to six month period. So, one of the things we are seeing, and I think buyers and sellers are open to, is in fact introducing earnouts to the capital structure. They may not always be tax advantageous to a seller if treated as ordinary income. So, that certainly is something that gives sellers discomfort. However, it is a little bit of that alpha factor, is your example. Let's say, a seller thought they were going to get seven times, and that's what they may have been able to trade at one or two years ago. And now, the market feels more like five to five and a half.

That's going to be unacceptable to trade. But somewhere in between or even less cash upfront but a higher overall purchase price over a two or three year period may be realistic and give buyers the comfort to transact. So, it is a little bit, it puts the risk back on the seller and the management team to perform, but there are creative ways to do this. So, earnouts would be one element.

The second, it is more complicated, but more private equity portfolio companies are discussing mergers. Let's assume cashless mergers to create value during this pause in transaction activity. That a lot of value can be created in the next year or two, awaiting the return to a more robust and active financial market, again, is something that ordinarily would be dismissed. But given two characteristics of the private equity community, less emotion than often an entrepreneur or founder and financial sophistication, they understand what they can do together in the power of one plus one equals three. So, that's another thing that we're seeing to try to bridge the gap.

The third would be related party and related fund transactions. There are a number of institutional investors and limited partners. The sovereign funds, the insurance funds, the large endowments in some of the family offices that are very interested in partial liquidity events, but a trade from fund three to fund four, or a carve out of certain assets where the existing limited partners have a choice to roll over into the new co-entity, or to have partial liquidity.

So, what I would say is that the capital markets are creative, they are agile, they don't change in a day's time, but there are some solutions, and those would be three of them. Continuation funds and fund-to-fund transfers. The second would be what I spoke about in terms of private company mergers, which have been scarce in my entire career. But are more open to this because you have professionals that specialize in an industry. They knew that one of the companies was a buyer or a seller to the other. You can create a lot of value, take out costs. Maybe there's a geographical expansion play. Maybe there is just the ability to have size and leverage, helps one of the companies. And now, you can create value, even if it's unrealized, in the hope for a stronger second half 2024 and 2025 in the capital markets.

Let me add one to that list. Your example of the private company merger. A buyer is not getting any additional equity. Into the buyer entity, it's not getting any debt. It's just using its own securities as the currency in that acquisition. That's cheap in the sense of you don't have interest on that. It's expensive in percentage points. You're giving a lot more of the buyer equity ultimately in that scenario, but it's definitely an attractive option. The alternative on the opposite end of that spectrum of percentage points is we see private equity funds willing to, whether this is a new platform or funding into a platform to do another acquisition, is to just do it all with more equity out of the fund. So, they put in more capital and don't have any debt on it, which the idea is often that that can be refinanced in a debt recap at a later point. And that's probably true that it will be able to be debt recapped at a later point.

But on that spectrum of percentage points, it has an interesting dynamic in that it swings it all the way in the other direction. If a typical, let's say a hundred million acquisition was going to be 60 in debt, 30 in equity from the fund and 10 in rollover, that would imply a 75-25 equity split on the buyer side. If instead, you get 90 of equity dollars from the fund and still have the 10 of rollover with an ITORs recapping at a later date. You can recap at a later date, but you've right then, locked in the relative percentages at a 90-10 basis instead of 75-25. So, all of these different workarounds have pressure points and slightly different economics that you got to wade through, but definitely see people exploring alternatives.

It's not guaranteed they're going to make money, but they're going to be creative, and they're going to do things that are less traditional. That's an excellent point in terms of that I didn't mention earlier is the rollover element from a seller can help bridge the gap as well. It obviously, creates alignment of two companies and management to perform post transaction, but it also shows the buyer that the management team and seller has a lot of skin in the game. So, rollover equity is definitely increasing. We're seeing that in a couple conversations where... There were times when rollover equity in hot markets would be sometimes zero in terms of the sales pitch of a private equity buyer. Today, that number is probably significantly higher. So, that is another element as well.

Bob, I think we can talk about these difficult M&A times all morning here, but let's wrap it at that. It's been a ton of fun walking through some of this stuff. And I really appreciate you joining me.

This is great. I rightly appreciate the invitation.

Sounds good.

Thank you for joining us on this installment of The Banker's Corner. To learn more about today's discussion, please email host Geoff Cockrell at gcockrell@mcguirewoods.com. We look forward to hearing from you.

This series was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this series, you acknowledge that McGuire Woods makes no warranty, guarantee or representation as to the accuracy or sufficiency of the information featured in this installment. The views, information, or opinions expressed are solely those of the individuals involved, and do not necessarily reflect those of McGuireWoods. This series should not be used as a substitute for competent legal advice from a licensed professional attorney in your state, and should not be construed as an offer to make or consider any investment or course of action.