Posted on: August 10th, 2023
Psychology is a key driver in the acquisition financing market especially when the public markets are bullish. During such times, acquisition financing lenders recalibrate their view of risk and use the public market bullishness as a proxy for private market credit conditions. This leads to a relaxation of the risk premium they use in their pricing and credit decisions. This creates a self-reinforcing effect and allows more deals through the credit screen leading to increased booked assets for the acquisition financing lender.
Despite the inherent differences between private acquisition financing and public equity markets, good times in the public market result in a beneficent lending market for acquisition financing. This also works in reverse especially during a period of financial stress which the economy has experienced over the past several years. Often the sheer upward momentum of a market results in lenders having greater conviction as to the attainability of growth projections.
While this premise is supremely debatable, a rising tide of enthusiastic animal spirits lifts all boats. The tendency to believe that cycles are a thing of the past is a rookie mistake yet repeated endlessly in the acquisition financing market. The groupthink of credit decisionmakers overshoots during bull markets leading to too many marginal deals getting closed. Usually this means that too much acquisition financing debt is provided with overly rosy growth assumptions. This creates a double whammy effect during a contraction when simultaneously and suddenly, EBITDA tanks the leverage ratio spikes.
Successful acquisition financing lenders that have made it through many cycles have a contrarian bent wherein they are fearful when the market is frothy and aggressive when the market is down. By leaning against the prevailing market winds, credit decision makers can nimbly tact between the currents and avoid the large waves that crash in the portfolio.