Europe’s leveraged finance markets have undergone some dramatic changes in 2003. After prolonged bondholder lobbying for improved security, the way in which LBO financings are structured has been altered forever. Meanwhile, investor demand for assets has outstripped supply across the leveraged loan, mezzanine and high-yield markets, putting sponsors in the driving seat when negotiating terms. The result has been increasingly aggressive financing terms. Joanna Hickey reports.
Europe’s leveraged finance markets had a good year in 2003. Volumes exceeded those in 2002 and, unlike 2002, when a dearth of activity in the first half was succeeded by a rash of deals in the second, deal flow has been steady throughout the year.
“At the start of 2003 there was uncertainty about whether the market would be robust or weak. But that uncertainty soon disappeared and it has been a very positive year, with few problem deals, very good supply and strong demand,” said Hamish Buckland, co-head of leveraged finance at JP Morgan.
According to Thomson Financial, 2003 LBO loan volume stood at $52.1bn by mid December 2003, compared to $43.9bn in 2002, $30.2bn in 2001 and $35bn in 2000. High yield debt volume ballooned to $16.2bn in 2003 (driven largely by cross-over and corporate issuance), up from just $3.6bn in 2002, $6.1bn in 2001 and $8.9bn in 2000. While mezzanine held steady on last year’s bumper volume, at $4bn compared to $4.1bn in 2002, $2.5bn in 2001 and $2.7bn in 2000.
Deal sizes are also getting larger. The average LBO loan swelled to $606m this year, significantly up from $482.7m in 2002, $458m in 2001 and $393m in 2000, according to Thomson Financial. However, with the exception of the €5.6bn buyout of Italian yellow pages publisher Seat Pagine Gialle, the jumbo buyouts that punctuated the second half of 2002, such as Jefferson Smurfit, Telediffusion de France and Legrand, were not been repeated in 2003.
Given the ongoing challenges of the IPO market, sponsors have been forced to seek alternative ways of exiting their investments. As a result, 2003 yielded an unprecedented number of recapitalisations and secondary buyouts, which, although traditionally regarded with suspicion by the leveraged market, were enthusiastically taken up due to extremely high investor liquidity across all three markets.
In the leveraged loan market the continuing lack of corporate M&A left banks with few lucrative lending alternatives, leaving them hungry for leveraged assets. The relatively low default rate of leveraged loans has encouraged a perception that the asset class is a reasonably safe and low risk one, increasing its attractions to lenders. Institutional investor loan liquidity is also strong, although perhaps still not as high as during its peak in mid 2002. First quarter difficulties in raising debt and equity for CDOs gave way to a more positive fund raising environment later in the year, with a total of 11 CDOs closed. Further CDO managers are currently warehousing for funds that should close next year, such as Duke Street’s Duchess III, Prudential M&G’s Leopard II, PIMCO of the US and Alcentra’s Jubilee III.
Meanwhile, the European subordinated debt markets performed very well in 2003. The high yield bond market has experienced a huge surge in both supply and demand, with investors clamouring for cross-over, corporate and leveraged buyout paper. The mezzanine market has maintained last year’s dynamic activity and new investors continue to pile into the market. In addition to the traditional mezzanine investors such as ICG, Mezzanine Management and Indigo Capital, more banks are buying into the asset class; as best exemplified by Goldman Sachs’s vast $2.7bn mezzanine fund. CDOs are increasing their mezzanine buckets, while high yield bond investors and US institutional investors are increasingly cropping up in mezzanine syndicates.
Given the extent of liquidity, investor demand far outstripped supply throughout the year, despite the buoyant pace of leveraged buyout activity. This put the private equity houses firmly in the driving seat when negotiating financing terms and conditions. “The leveraged finance market is the most aggressive it’s been for several years. Unusually, all aspects of the market, bank and institutional investor liquidity and the mezzanine, high yield bond and US leveraged finance markets, are all very aggressive at the same time,” said Oliver Duff, head of loan syndication at Goldman Sachs London.
Intense competition among banks for mandates has further contributed to the private equity houses’ negotiating power. More and more banks are looking to underwrite and lead deals and are constantly pushing the structuring envelope in order to give themselves a competitive edge over their peers.
As a result, structures have got increasingly aggressive as the year has progressed. Leverage has been pushed inexorably northwards and is now between 0.5x and 1x higher across the board than it was in 2002. Total debt to EBITDA has approached and even topped the 6x level in more than a handful of deals. For example, the Seat Pagine Gialle jumbo financing carried total debt to EBITDA of 6.7x and senior debt of 4.6x, while German academic publisher Springer came out at 6x total debt and 4.5x senior debt and French pipes company Fransbonhomme had 5.7x total debt and 4.4x senior debt. When capital expenditure is stripped out of EBITDA, multiples soar even higher. For example, French tiling firm Terreal’s total debt reached 6.4x EBITDA when capex was factored out.
While leverage multiples of 6x EBITDA are not overly worrying for deals in stable, cash flow positive sectors in strong economies, they are a cause for concern when they are applied to more volatile, cyclical companies in more troubled economies. Yet the market’s general acceptance of higher multiples in 2003 has led to a number of cyclical sector buyouts being overleveraged, something that does not bode well in a rising interest rate environment.
Even more perturbing is the fact that all-important debt service cover to free cash flow ratio, which gauges how much free cash is available to pay down debt, is falling, to below 1.3x throughout the life of the loan in some cases from 1.3 to 1.4x last year.
In addition, the average equity component has been steadily eroded throughout the year. Whereas 35% equity was the market norm until 2002, increasingly deals are now emerging with less than 30% in equity. For example, bankers say Viterra and Fransbonhomme had just 26.5% equity, while Materis had 28% and Terreal had 27%. Secondary buyouts especially are driving this trend, with a general acceptance of more aggressive terms on familiar credits that have already been through the rigours of one buyout.
Despite such aggressive terms and conditions, extremely strong investor liquidity has meant nearly all transactions have fared well across all three markets. The only notable exception to this was paper and packaging firm Linpac’s senior debt financing, which emerged with total debt to EBITDA minus capex of nearly 8x. Not only were these multiples so much higher than all other transactions, but also several companies in Linpac’s business sector were encountering performance issues, so bankers felt compelled to refuse it. Linpac apart, however, oversubscriptions have been achieved on many leveraged loans this year.
Although the anticipated interest rate hikes could spell trouble for highly leveraged companies in cyclical industry sectors, at present most bankers do not appear overly concerned. They argue that about 60% of the interest rate risk is usually hedged out for the first three years of the leveraged loan, after which most deals are expected to have been refinanced or taken out. In addition, the belief that the economy will continue to improve, with the resulting positive implications for companies, means bankers anticipate steady cash flows and relatively swift de-leveraging.
Europe’s high yield bond market has been active in 2003 and although “fallen angel” crossover credits dominated the market, a number of leveraged buyouts, such as Brake Brothers, Safilo and Fiat Avio were successfully completed.
“The European high yield bond market has been dominated by cross-over credits, rather than LBOs this year. This is a positive development; too much reliance
on B3/B- credits had made the market too volatile,” said Aengus McMahon, assistant director fixed income, Henderson Global Investors.
However, those LBO bonds that did emerge were successfully taken up by the market, which has been extremely upbeat and healthy in tone. “The high yield market is there again for LBOs. Investors have had a great year, with few defaults and almost 30% returns compared to -5% last year, -14% in 2001 and -8% in 2000. The outlook for 2004 is positive, with the improving economy, although we may not be able to match this year’s returns again,” said Martin O’Reeves, director of European Credit Research at Alliance Capital.
Although conditions in the high yield market have been favourable in 2003, all but a handful of LBOs, usually the very largest ones that mezzanine investors could not absorb, have gone the mezzanine route. Mezzanine is still the debt instrument of choice for sponsors seeking €250m or less of subordinated debt and where the exit is expected within three years. Not only has mezzanine been viewed as a more stable market than bonds in recent years, but also the bond route is more time-consuming and involves more disclosure.
“Many LBOs do not belong in the public bond market, as it involves significant expense, with public disclosure and quarterly account updates for investors. Also, many LBOs want to renegotiate or refinance early down the line and therefore need more flexibility than the high yield market is prepared to offer,” said Henderson’s McMahon.
The dramatic surge in mezzanine volumes and liquidity has been one of the main themes of Europe’s leveraged finance market in the past two years. “The mezzanine market really came into its own in 2002 and this year has been a consolidation of that. Mezzanine is now used for all but the biggest buyouts, with deals of €200m to €300m now regularly seen and who knows what the upper limit for the right deal might be,” said Christiian Marriott, investor relations director at Mezzanine Management.
The average mezzanine tranche swelled to $80.6m in 2003 and $82.6m in 2002, up from $55.8m in 2001, according to Thomson Financial. Telediffusion de France kicked off the trend for larger mezzanine pieces with its €300m deal in November 2002, closely followed by Elis, with a €290m piece and Gala in early 2003 with a £190m deal that raised over £300m in commitments. Other sizeable mezzanine deals this year include Springer’s €265m, Ontex’s €165m and Viterra’s €197.5m. The market is now speculating that up to €500m could be possible for one mezzanine deal.
This year the number of mezzanine market players has continued to increase. As well as the traditional investors, at least ten CDO managers are buying mezzanine for multiple funds in their portfolio, while CDO managers such as Duke Street and Alcentra are also rumoured to be setting up stand-alone mezzanine funds. In addition, more and more banks are buying mezzanine, either on their own balance sheet, or through specifically established mezzanine funds.
Elsewhere, a number of private equity houses are asking arrangers to show mezzanine paper to some of their limited partners, such as big US pension funds and both European and US high yield bond investors have also entered the market. “Market liquidity is extremely strong now. In addition to the traditional CDO and bank investors, one trend is that the limited partners of some private equity firms have also started to co-invest in the mezzanine of their deals,” said Mezzanine Management’s Marriott.
Traditional mezzanine investors tend to stick to the warranted tranches, preferring the significant upside that one successful equity investment can yield. However, the CDOs and high yield bond players prefer the certainty of the higher contractual pay in warrantless mezzanine. In order to appeal to every possible investor, today’s classic mezzanine deal usually has one warranted tranche and one warrantless tranche.
Given the success of the high yield market this year, in 2004 sponsors could veer towards the bond market as well, however. “In previous years, the stability of mezzanine has prompted many sponsors to favour it, although timing to exit, availability of financial statements to a bond market standard, disclosure, deal size and currency are also factors to consider. But the high yield market has been strong for a while now and its 8% to 9% yields are very attractive to sponsors when compared to the 14% to 16% they have to pay for mezzanine,” said JP Morgan’s Buckland.
Revolutionary structural developments
Last year will go down in leveraged finance history as the point at which bondholders finally succeeded in their age-old quest for improved security. After years of lobbying for a better position in the capital structure, bondholders are now routinely getting upstream guarantees from the operating company and, in some cases, a second charge on asset security like mezzanine investors.
The first breakthrough came in April, when, after much wrangling, senior debt lenders begrudgingly approved a waiver to the Brake Brothers loan to allow upstream guarantees for bondholders, ahead of the company’s €175m high yield issue. As compensation, the loan lenders were offered a waiver fee upfront, plus 50bp extra on all tranche spreads, taking the term loan C to 375bp; the highest LBO loan pricing then seen in Europe.
After the high-profile precedent set by Brake Brothers, arrangers strove to create compromise structures that both senior debt lenders and bondholders could live with. The result was the £225m Focus Wickes “hybrid” mezzanine note. This contained elements of both the mezzanine and bond products, with a second charge on assets, operating company upstream guarantees, but no call protection.
Although it was ultimately labelled “a high yield bond without the call protection” and was sold just to bond investors, Focus was nevertheless heralded as groundbreaking. It had important implications for the market in that it was the first ever listed mezzanine note. It also cemented the need to accept better bondholder security in senior debt lenders’ minds.
The market has now permanently moved to bondholder upstream guarantees of some sort. Senior debt lenders approved the new bondholder security structure for ensuing LBO bonds such as Fiat Avio, Safilo and the forthcoming Seat issue. Bankers expect to see more innovative new structures next year, as arrangers continue to tailor structures that give higher security to bondholders yet remain acceptable to senior debt lenders.
But while progress has been made in that senior lenders now accept bondholders cannot be treated, as previously, as quasi-equity investors in terms of their rights in a default situation, the significance of the bondholder security gleaned thus far remains debatable. “We are pleased we now have upstream guarantees. But we are still not convinced of our position in a default situation. Things have improved, but there is still some way to go,” said Henderson’s McMahon.
Many of the upstream guarantees seen this year have had strict limitations and often the bondholders have not been given the ability to accelerate in a default situation. For example, Focus had a permanent standstill on bondholders’ asset security charge, effectively rendering it meaningless. Also, the usual mezzanine 90-day standstill on the guarantees following payment default was doubled in Focus to 180 days.
The market is still a long way off routinely giving bondholders the second ranking security that mezzanine investors enjoy. Yet for now, the structural subordination issue has died down, with senior debt lenders happy to approve upstream operating company guarantees and bondholders, at present, appearing to be mollified. “Despite the bells and whistles still put around the guarantees, bondholders have achieved significant improvements in their security this year and are happy with that. They never sought to rank pari passu with senior debt lenders, they just wanted more security than equity investors,” said JP Morgan’s Buckland.
Time will tell. Given the enduring limitations, the dispute could easily be rekindled, especially if the high yield market becomes less attractive to investors or if the limitations of their improved security position are highlighted by the next default situation. “Bond investors now routinely get upstream guarantees, but it is something of a hollow victory as they often have release provisions that limit their value. In many cases, bondholders are still not getting second ranking security. This year’s very strong high yield market meant that many bond investors have ignored the less than perfect resolution of the subordination debate. So although the row has died down for now, it could be revived,” said Goldman Sachs’ Duff.
Looking forward, the first half of 2004 looks set to be extremely busy. A slew of bidding competitions and buyout auctions were concluded in Q4 2003 and the supporting financings are lining up for launch in Q1 of 2004. Financings for the buyouts of the £1.72bn Debenhams, the circa €1.5bn MTU, the £624m Weetabix, the €1bn Brenntag, ABB’s circa $1bn Oil, Gas & Petroleum unit and the €3.1bn Celanese are just some of the sizeable LBO transactions already set to launch.
Bankers anticipate another strong year in the leveraged buyout arena. All the signs of an active market are there; European corporates are still restructuring and looking to divest non-core assets, private equity houses still have substantial funds that need to be invested, while investor appetite is still healthy. The market drivers will be slightly different, however, in that there will be less distressed sellers than at the start of 2003. But as corporate M&A activity returns, it will once again spawn the post-merger divestments that so boosted the LBO market in the 1998 to 2000 era.
Given the enduring market liquidity, a more conservative financing environment is not anticipated. However, although some fear if corporate earnings rise in line with rates, leverage could rise even further, most bankers feel the top of the market has been reached. “Leverage multiples are close to their peak now and there is not much room to move higher. Next year, if top-line growth rises along with interest rates, leverage levels should remain static, but they will fall slightly if it does not,” said JP Morgan’s Buckland.