As 1999 begins to wind down, we have found ourselves bombarded by illnesses, both real and metaphorical. Our computer systems are threatened by a Y2K Bug that could scuttle their operations, while encephalitis and E. coli have become the subject of all-too-frequent newspaper headlines. And, oh yeah, flu season is right around the corner.
But perhaps more worrisome for buyout firm general partners is not the illness that may infect their personal computers or even the bugs eyeing their immune systems, but rather a sickness that, sources agree, has overtaken the sponsored lending market in the course of the last six months.
Although for the second quarter of 1999, a robust total of $87.8 billion was recorded in leveraged volume-an all-time quarterly record-the deal volume involving financial sponsors comprised just $22.53 billion of that total, or 25.6%, according to Loan Pricing Corp. (LPC) and Goldsheets. That percentage compares with a 37.6% chunk that buyout sponsors garnered from the first quarter’s total.
More importantly, LPC found that of the more than $22 billion of sponsored volume, a mere $4.82 billion, or only a little less than 21.4%, went to LBOs, whereas more than $17.7 billion was dedicated to non-LBO deals.
“The market clearly is not overly receptive to new paper,” says Norman Alpert, a managing director at New York-based Vestar Capital Partners.
Alpert’s commentary on the debt market mirrors those of other industry observers, including G.P.s and lenders alike, and foreshadows what sources predict will be an even slower second half of the year for lending to traditional LBO deals.
“The market has become more difficult as the year has progressed, especially in the high-yield market, which is extremely difficult,” says Mark Williamson, a managing director at San Francisco-based Fremont Partners.
For the second quarter, LPC also recorded a decided notch down in average financing size for LBO deals. Whereas the second quarter recorded an average LBO-related financing of $299.52 million, the first quarter posted an average LBO financing of $353.33 million-a drop of approximately 35%.
Sources attribute much of the reduction in average LBO-related financing size in the second quarter to a spate of non-traditional deals by buyout firms, in which the groups were equity participants in the acquisition of minority stakes of publicly traded companies.
For example, the second quarter saw the completion of the $1.8 billion credit facility for Patriot American Hospitality that backed an equity infusion in the form of convertible preferred shares by Apollo Advisors, Thomas H. Lee Co., Beacon Capital Partners and Rosen Consulting Group (BUYOUTS March 22, p. 1). Also in the second quarter, the $1.1 billion credit facility for RCN Corp. was completed, which went hand in hand with a $250 million equity investment through the purchase of convertible preferred shares by Dallas-based Hicks, Muse, Tate & Furst Inc. (BUYOUTS April 5, p. 12).
Sources say the trend of financings for non-LBO investments dominating the sponsored volume likely will continue in the third quarter, owing in large part to the completion of the $7 billion financing backing the acquisition of Browning-Ferris Industries by Allied Waste, in which both Apollo and The Blackstone Group played integral roles as minority investors.
That the larger buyout firms seem to be putting their money into non-traditional investments seems to bear out, at least in the second quarter, according to LPC. The largest financings for LBO deals recorded last quarter included the $475 million credit facility for Welsh, Carson, Anderson & Stowe’s recapitalization of Concentra Managed Care, a similar size facility that backed Vestar’s buyout of Consolidated Container, the $445 million in debt that supported Joseph Littlejohn & Levy’s acquisition of Transportation Manufacturing Operations and the $400 million that backed the LBO of American Media by Evercore Partners, according to LPC.
These deals pale in comparison with some of the larger facilities inked in the first quarter, including the $1.46 billion backing Madison Dearborn Partners’ acquisition of Packaging Corp. of America (BUYOUTS Feb. 8, p. 5) and the $1.05 billion facility behind the buyout of Centennial Cellular by Welsh Carson and Blackstone.
Indeed, perhaps the chief suspect currently hampering the debt market is an extremely fickle high-yield market, especially for LBO firm-backed deals. This fickleness has led, sources say, to buyout firm portfolio companies paying premium coupons on their bonds and often having their original offerings reduced and filled in by larger amounts of both equity and senior debt.
“Pricing has backed up again, there have been cases of companies with high-yield offerings at 13%,” says Tyler Wolfram, a managing director at Cornerstone Equity Investors. “The market is not nearly as friendly as it has been.”
The reason for the backup, sources say, is a lack of funds flowing into high-yield bond mutual funds, thereby stemming demand for new product. In addition, bond investors evidently have learned a lesson from last year’s credit blip, during which their holdings were radically devalued, and a prime buying opportunity was missed because of illiquidity in their portfolios.
“Last year bond funds were fully invested but didn’t have the cash to buy things,” says Fremont Partners’ Williamson. “They may be thinking they want to avoid that this year. Since June, [funds] have been very conscious of holding some of their assets in cash.”
Singing the High-Yield Blues
The lack of liquidity in the bond market has led to an environment where institutional investors more easily can pick and choose amongst high-yield products, often squeezing even greater coupon payments out of LBO portfolio companies. “If you are willing to tweak the pricing a little, you generally can get an offering done,” says Mathew Lori, a principal at Chase Capital Partners. “It’s a fickle market, and when the deal flow is a little tighter, it’s a little more difficult to get a deal done in an out-of-favor industry.” Lorri adds that Chase Capital in the first half of the year had two deals that were backed by high-yield offerings that were difficult to complete because they fell into areas not currently favored by high-yield investors. He declined to comment further on the deals.
One case that serves as a barometer of the hit-or-miss mentality of the high-yield market is the comparison between Vestar’s buyouts of Consolidated Container and St. John’s Knits. Although both companies were manufacturing companies with similar price tags being bought by the same financial sponsor and were brought to the high-yield market a scant three weeks apart, they were met with radically different receptions, sources say.
In the case of Consolidated Container, Vestar was able to get the high-yield portion of the deal done with a note that included a 10.5% coupon. However, sailing was not nearly as smooth for St. John’s Knits. The acquisition of the women’s clothing manufacturer was originally supposed to include a high-yield portion with a 12.5% coupon, but Vestar eventually had to raise the amount of the coupon and reduce the size of the offering-filling in the difference with both senior debt and additional equity-to pass muster with investors.
“Clearly the Consolidated Container deal was received much more favorably, and I would make the argument that the two deals are not that much different,” Vestar’s Alpert says.
Senior Supports Lagging High Yield
As always, when one market begins to lose strength, another will fill its shoes, and in this case, sources say the senior market has stepped up to buttress the lack of high-yield offerings-albeit with more caution and higher pricing than in the first half of 1998.
Sources say they are seeing pricing of between 250 and 300 basis points over LIBOR for term-A tranches, an increase of approximately 25 basis points over market prices six months ago.
“The theme in 1999 is that senior lenders are maintaining quite a bit of discipline,” says David Brackett, a managing director at Antares Leveraged Capital Corp. “If a deal has problems, we tend to see it being done for about three-times EBITDA, whereas a solid company can get debt on a four-times-EBITDA basis.”
G.P.s trawling the middle market agree that banks have become a little more tight-fisted. “Over the last four or five months, we have experienced a little more conservatism with regard to the high-yield market and the senior market,” says Ernest Jacquet, a managing partner at Boston-based buyout shop Parthenon Capital. Jacquet says his firm, which largely targets acquisitions of less than $250 million, has been putting as much as 40% equity into recent deals. While he notes that much of this conservative financing structure is based on most of these deals being consolidation plays-thereby having a need for more equity than a stand-alone investment-he does concede that skittishness on the part of lenders also is fueling the increased percentage of equity. “Obviously we would prefer a more efficient capital structure, but several of the transactions that we have completed require add-on acquisitions and lenders are more comfortable if they feel you are fully behind the company,” Jacquet says.
Looking ahead, most sources agree the remaining months of the millennium will be relatively slow in the sponsored lending market, in part because many banks already have posted strong revenue this year and are not willing to risk these gains in the last two quarters, but also because of growing trepidation over liabilities arising from potential Y2K problems.
“Amongst sponsors, it’s pretty unanimous that they won’t be closing deals in December of this year,” says Daniel Marszalek, group president of Heller Corporate Finance. “They figure why take the risk in a month? They will be locked up and ready to go, and they might even have financing in place, but they just won’t pull the trigger until next year.”