The dramatic reduction in the funding appetite following the economic downturn is illustrated below:
| |
Pre-crisis |
Current |
| Debt/EBITDA |
Up to 4 times |
2 to 2.5 times |
| Debt Service Cover Ratio |
Minimum 1.2 times |
Minimum 1.4 times |
| Gearing ratio (debt:equity) |
70:30 |
60:40 |
Although levels of debt available have dropped, pricing of debt provided has increased between 1% and 2% due to changes in the following key pricing drivers:
- Risk rating – an uncertain outlook for the economy, specific sector concerns and resulting clients’ weaker performance have resulted in a general increase in companies’ risk ratings
- Debt repayment tenor – the longer the tenor, the more expensive the cost of capital is
- Liquidity premiums are now well in excess of 1% (100 basis points), up from 0.3% (30 basis points) before the crisis. The current trend is downwards, but a return to precrisis levels is not expected.
Adverse developments in bank funding fundamentally changed the approach to acquisitions. For example, assume a manufacturing business is sold in its entirety at a value of R100 million with an Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA) of R20 million, as outlined below:
| |
Pre-crisis |
Current |
| Bank debt |
R70 million (3.5 times EBITDA but capped at 70% gearing) |
R50 million (2.5 times EBITDA and 50% gearing) |
| Equity |
R30 million |
R50 million |
| Interest expense assuming interest only repayment |
R7 million per annum |
R6 million per annum |
Although there is an interest saving, it is not proportionate to the reduction in debt funding, which means this debt is more expensive.
Typically equity funds require an Internal Rate of Return (IRR) of approximately 30% per annum, so assuming no dividend flow over a five-year period and disposal of its shareholding at the end of year five, the investor would require a total of R125 million of equity proceeds to achieve the targeted IRR.
This type of growth is typical of a high-growth company, such as services/new technology businesses, but eliminates a substantial portion of the corporate market.
The following is therefore needed for a normalised banking environment:
- The sales price expectations gap needs to narrow as sellers realise that the ‘good old days’ are over and they reduce their asking price. Recent upward revaluations of the Johannesburg Stock Exchange might negate this process.
- More involvement from Life companies who do not have to comply with banking capital requirements and their ‘deposit’ base (policies) allowing for matching longer term funding (specifically project finance).
- More prominent involvement from mezzanine funders. Although this funding is expensive (15% to 20% IRR), it provides additional capital to the deal and reduces the private equity required to conclude a transaction.