The corporate buyout environment was extraordinarily competitive in 2018 and remains hot moving into 2019.
While investors have allocated more capital to private equity over the past five years than any time in history, factors inhibiting sponsors’ ability to transact include high valuation multiples, debt limits, and new tax laws limiting interest expense deductibility.
With increased competition for acquisitions coming from other sponsors, as well as strategic buyers (like a corporate buyer in the same industry/business), sponsors are looking to alternative forms of finance to attain fund return mandates and are using sale-leaseback transactions to unlock the value of their owned real estate.
Why a Sale Leaseback?
There are many benefits to the sale-leaseback transaction, including:
- It provides the ability to unlock substantial illiquid capital for redeployment in core business (or to paydown debt, dividend recap), while providing long-term occupancy and control of the property.
- Residual value is optimized and achieved immediately, avoiding residual risk when the property is no longer required.
- Lease payments can be fixed for the base lease term and beyond, at levels that can be a significant discount to market rents.
- It allows the realization of 100% of a property’s market value without the prohibitive covenants and restrictions typical of most corporate finance instruments.
CBRE Corporate Capital Markets does more of these transactions than anyone in the world ($20 billion+ since 2010). We’ve experienced a tremendous uptick in recent years in the amount of sale-leaseback valuation requests for sponsors in the midst of mergers and acquisitions. Typically, these sponsors look to our team to execute the sale leaseback contemporaneously with their acquisition, often using the proceeds from the sale as part of their acquisition finance. This allows them to use less leverage and/or call upon less limited partner equity.
High Valuation Multiples:
The median valuation multiple for transactions rose to 8.3X in 2018, up from 7.9X in 2017. As cap rates have held relatively low, there generally exist what we refer to as “multiple arbitrage” in acquisitions that come with owned real estate.
For example, CBRE recently executed a portfolio sale leaseback for a sponsor target with approximately $190 million in topline revenue, $25 million in EBITDA, and leveraged approximately 3.0X – what we would consider a typical middle-market credit profile. This sale leaseback process was highly competitive and traded at a 719 basis points (bps) cap rate, the inverse of which represents a 13.9X multiple. Considering the median multiple for acquisitions in 2018 was 8.3X, the sale lease-back provided an opportunity for the sponsor to “buy down” the multiple paid for the overall transaction.
With cap rates for companies with what CBRE would characterize as “typical middle-market credit profiles” in the 685 bps to 835 bps range (CBRE losed comp statistics), the sale-leaseback transaction is almost always accretive, providing ample multiple arbitrage.
Debt vis-à-vis high multiples (6X):
Leverage remained relatively flat in 2018 with average debt used in a buyout of 53.6%. With valuation multiples continuing to rise, sponsors are left searching for options to make up the difference.
Furthermore, an often-overlooked aspect of the 2018 Tax Cuts and Jobs Act (TCJA) is Section 13301. Historically, private equity sponsors could deduct interest expenses on debt from pre-tax income, which has been a major catalyst behind the growth of leveraged buyouts. Former tax laws made debt preferable to using equity, and sponsors sought to maximize their leverage. This is unlikely to remain the case as the TCJA imposes prescriptive restrictions.
Moving forward, a company can only deduct interest equivalent to 30% of EBITDA with the threshold limited even further in 2022, curbing the amount to 30% of EBIT. This will limit the ability of sponsors to use the amount of debt they have become accustomed to using for buyout transactions, making them less competitive in bidding processes that include strategic buyers. An alternative to less debt is for sponsors to use more equity, but this can be expensive. CBRE believes the high cost of equity is fueling the desire to monetize real estate instead.
Despite the aforementioned, conspiring dynamics, vast amounts of capital continue to be allocated to private equity. “Dry Powder” (the measure of committed, yet uncalled capital) reached an estimated $1.8 trillion in 2018, as reported by McKinsey in their annual review.
While the monetization of owned real estate assets through sale leaseback is nothing new, we believe we are experiencing a “mini-boom“ in activity as sponsors are exploring creative ways to unlock value and meet fund return hurdles in an increasingly competitive environment.
As more sponsors become aware of the benefits of this alternative financing solution, the sale-leaseback mini-boom has no clear end in sight.
By Vincent Polce, Vice President, Corporate Capital Markets, Denver, CBRE.
This article originally appeared in the Colorado Real Estate Journal.