Leave the Rate Roller Coaster to Others. I’ll Take the Lazy River

Key Takeaways

• Higher interest rates are potentially a boon for sale leaseback (SLB) activity.
• With traditional borrowing capacity limited and expensive, SLBs remain an interesting source of liquidity.
• Add-ons fuel the majority of current SLB M&A volume.
• There’s been robust activity in manufacturing, food production, car washes, outdoor storage assets, QSR, auto dealerships, medical offices and gas stations/C-stores.

While the Fed’s aggressive rate hiking policy is weighing on many consumers, businesses and CRE sectors, it’s been a surprising tailwind for the SLB sector -- not in terms of pricing, but in terms of activity. Industry estimates show that 2022 was a record year based on dollar volume of SLB transactions. With Fed policy suggesting no rate cuts until 2024 at the earliest, 2023 could be another strong year for SLB activity.

Relative cost of capital in action

What gives? Isn’t M&A in the doldrums? It is, down about 41% across North America last year, according to S&P Global Market Intelligence. But the relative cost of capital of a SLB – while higher than last year -- is more attractive, especially when compared to the fast-rising cost of corporate debt and other traditional financing options.

Middle market companies and their sponsors have a myriad of financing options, such as traditional bank debt, mezzanine debt, bonds, asset financing, equity, and of course, SLB financing. But higher interest rates have taken their toll on bonds and bank debt, both of which have increased by more than 400 basis points in the past year. SLB cap rates have increased as well, but only by 100 to 150 bps over the same period.

No decrease in leverage here

Separate from cost of capital though, is availability of capital. Traditional lenders are pulling back on the amount they’re willing to lend sponsors, to the tune of half to a full turn of lower leverage. This means less overall leverage is available from traditional banks. But this has not impeded the SLB strategy much. True, the cost of capital has changed, but the amount of capital provided, really has not moved. The SLB strategy always provides financing for 100% of a property’s value. As a result, the availability of capital via SLBs hasn’t moved much – even with higher cap rates. That’s largely because rents have also increased during this period, and rents have a disproportionately larger effect on valuations, as you’re applying a multiple to rents in order to calculate value.
 
Add-ons leading the pack

A trend we started noticing late last year is that the bulk of our SLB business for private equity M&A has been associated with a PE firm’s add-on acquisitions, not new platform investments. This trend is not surprising as it seems to be a broader reflection of the current M&A market in which add-ons are leading the way in terms of deal activity. In 2022, about 72% of all North American buyouts were add-ons, versus platform deals according to a Bain & Company report released this week. 

“The appeal and feasibility of smaller M&A deals can be seen in the growth of add-ons, deals financed from the balance sheet of a portfolio company, usually to expand its footprint or add an adjacency,” noted Bain. Increasingly, said Bain, add-ons have been “multiple arbitrage plays” in which a GP buys smaller companies at lower multiples to build them into a larger one “that will command a higher valuation.”

Given these low acquisition multiples for add-ons, I have found the SLB equation makes a ton of sense as the PE firm is typically generating substantial arbitrage between the implied cap rate multiple of the SLB and the acquisition multiple of the deal. Since add-ons are typically smaller deals, the spread through the SLB can be substantial compared to the enterprise value of the target business.

You can re-familiarize yourself with the benefits of the sale leaseback strategy especially for add-on acquisitions, here. A few excerpts are re-emphasized below.

Best candidates for SLB

The best candidates for executing this strategy are PE add-ons to platform companies. The reason is simple – it’s all about the credit bump. Even with a sophisticated seller, the value of a SLB is highly driven by the credit of the underlying tenant. If you immediately grow and improve the credit of a smaller standalone business by bringing it under the umbrella of a broader platform company, the value of a piece of real estate that’s leased on a long-term basis to that company should increase, everything else being equal. This is the case with add-ons.

Assume you’re a PE owner of a $40 million EBITDA plastic injection molding business – we’ll call it Big Plastics. You’re evaluating the add-on of a $5 million EBITDA standalone operation – we’ll call it Chelsea’s Extrusion House. If Extrusion House executed a SLB on its own of its manufacturing facility in Wisconsin, maybe it could get $12 million for it. If instead, the PE owner of Big Plastics engaged our firm to run a simultaneous SLB of the Wisconsin facility as part of its acquisition financing of the add-on, then the PE owner could generate $20 million from the SLB.

The incremental $8 million from the transaction above is a combination of several important factors, most notably:

1) The higher rent that the broader platform company could afford and also justify to SLB investors, and

2) The lower cap rate given the significantly stronger credit of the $45 million-plus EBITDA business as guarantor compared to the $5 million EBITDA business as guarantor. By bringing the target under the larger umbrella and by significantly improving the credit profile of the lease guarantor, the SLB value inherently increases.

This creates significant arbitrage as the target’s seller could not achieve this value on its own. Hence, the PE firm creates spread through the immediate credit enhancement for which it can capitalize along with the acquisition of the target. How? By using the SLB to finance the acquisition. Often the spread is large enough for the sponsor to use the SLB capital to finance the acquisition of the add-on in its entirety.

Attractive sectors of the SLB market

There’s a lot of gloom and doom in the commercial real estate sector generally, but institutions still have to invest. Buyers can’t sit on the sidelines forever. Private equity firms are still looking for attractive financing sources, and business owners are still looking for accretive forms of liquidity. We’ve been busy in many asset classes, most notably manufacturing facilities, car washes, outdoor storage assets, food production/cold storage, QSRs, auto dealerships, medical offices, healthcare facilities and gas station/convenience stores. These deals are a reflection of where our private equity clients are spending their time currently, especially when evaluating smaller add-ons to their existing portfolio companies.
 
Conclusion

As we head into March Madness season, I’m reminded of what the legendary Michael Jordan liked to say: “You miss 100% of the shots you don’t take.” During challenging times like these: hope is not a strategy; neither is sitting on the sidelines. With the right partner on your team, you can unlock opportunities that others aren’t even seeing.