A couple years ago, interest rates were extremely low. And, says Evergreen Capital Partners President and Co-Founding Partner Dominick Schiano, a lot of banks, both traditional lenders and private lenders, were competing for deals.
“You had low interest rates, and you can do maybe a 50 percent or less equity deal and the rest, leverage. Fast forward. Today, rates are much higher. And I think it's very, very difficult to get much more than 40 percent equity in the deal. So, it becomes a very, very simple math problem,” Schiano said at the Detroit Smart Business Dealmakers Conference. “If you're a private equity firm, you're going to underwrite to a 20-25 percent return. If you have the same exact company under those two scenarios — before lower interest rates, higher leverage; today, less leverage, higher interest rates — just that simple math says the business is worth less; same exact business, two different times, two different parts.”
He says he doesn’t think the interest rate is ever going back to 2 percent. Though it could come down a bit from where it sits this year, a higher rate is likely the new normal. So, deal activity somewhat picking up can be attributed to a realization of what businesses are worth in this current environment.
Higher interest rates are affecting all businesses regardless of industry. Cyclical, capital-intensive businesses are having the toughest time getting underwritten today. And another part of the issue is that a lot of people look at what's happened at that business over time. And the recent history is clouded by COVID. While some businesses benefited from that environment, others struggled. That requires going back and attempting to normalize the numbers. But at the end of the day, it's coming down to terms and rates.
“I've looked at some term sheets this week that I never thought I'd see again, with those extreme rates, and very severe terms and non-call protection, everything else,” he says. “And the more cyclical, more capital intensive the business is, the more difficult.”
Sellers, he says, are negotiating differently in today’s environment than they had in the past. He says he believes that’s because there had been a sense that the economy would improve, and interest rates were going to come down soon. And with recent events, many are more worried that won’t happen while also being concerned about a decline in the economy. So, he says if a seller has a real reason to exit, they're more ready to engage.
The hope, he says, is that as more private lenders come in, they compete more for the deals and sellers will adjust their expectations for what they want and that will make for an improved deal environment.
He says what holds up deals is valuation and financing.
“First, you got to get the valuation,” Schiano says. “And in today's world, there's still a chasm on buyers and sellers. And then financing takes long,” he says. “Everything is people. It's a people business and relationships count. They add to your pile of money if you have a good relationship.”
Another way to counter the issues in today’s market is creative structuring.
“I haven't seen as many deals today that have earnouts, all equity deals that get refinanced later on, other structures where sellers can get benefit from success in the future, plans for recaps in the future, if things are going well, that type of thing,” he says. “So, if two people really want to get a deal done, and they're both reasonable — and I use that with a capital R — a deal will get done; there will be a way to get two people together to get a deal done in a reasonable way. And just today, I think, before it was, ‘I’ll pay this much, I’ll borrow this much, and you go home.’ Today, it's more rollover, equity, more structured debt, more earn out. And I expect that to continue, really, for the foreseeable short-term future.”
He says many sellers haven't done rollover before. That requires explaining the terms to them.
“I do like to sit down with a seller who's inexperienced in this type of deal and show them what their equity could be worth over time under certain conditions,” Schiano says. “That's not saying we're going to sell in two years, five years or whatever. We could recap the business 12 times, too. But I do like to sit down and say, ‘Here's what your equity could be worth under these conditions.”
