Most middle market M&A transactions are financed using a combination of equity and debt contributions. Within the debt contribution, a deal may have multiple types of debt in the mix, both senior and junior, or mezzanine debt. Debt has a lower cost of capital than equity, so the return on equity increases as the percentage of debt in the deal goes up. The challenge is to use as much debt as reasonable, without hitting the point where cash flow from the entity cannot service the debt. It’s a balancing act so credit statistics and cash flow modeling are a guide when arranging M&A financing.
At first glance, the average debt levels spiked in the second quarter of 2013. However, the spike may have more to do with the small number of reported transactions rather than reality.
As Andy Greenberg, CEO of GF Data, commented in a recent editorial piece, the capital markets are by their very nature “opaque”. While the universe of debt providers tends to be quite concentrated (between GE Capital Antares and the other 10 top debt providers, they account for 80% of the debt markets), by contrast the market share of any one active middle market sponsor would likely be in the single digits. In addition, the types of private sponsors run the gamut from PE sponsors who maximize leverage, those that prefer using less leverage, family offices, and users of tranche products. These varying sponsors are considered equal when computing averages, yet this is likely not the case and makes the data difficult to put into context. GF Data is carving out some additional categories for reporting purposes in an attempt to make the numbers more meaningful in the long run.