With everyone getting into debt buying these days, including private equity firms, the number of new faces and the amount of liquidity in the debt market has caused consternation among many private equity firms which traditionally prefer to know who is holding their loan notes. CVC has reportedly been very concerned about hedge funds buying LBO debt, so much so that the group is launching a debt fund in the next few months as a response.
Put simply, it is really only a concern when the market takes a turn for the worse, the creditor and debtor won’t have to deal with each other. This is a point emphasised by Alicia Videon, a partner at DLA Piper, when she says: “In a normal economic environment, you don’t really care too much, but in a distressed environment the kind of debtor you have matters a lot more.”
The fact that this is such a hot topic right now demonstrates the recognition by some firms that bad times are just around the corner (it is also possible that it could matter when the market is strong. If a company wants to make a bolt-on acquisition for a price that requires it to consult its debt holders, it could find itself talking to people it doesn’t want to and who aren’t of the same opinion).
One industry source said that Apax and Cinven are so worried about it that the two managed to have absolute consent written into the bank covenants. Absolute consent is very rare and very difficult to achieve; more common is that consent shall not be unreasonably withheld, whereby the borrower must be consulted when debt is traded. Absolute consent gives the borrower complete control over who owns its debt, and such a move by Apax and Cinven (and most probably all of the other larger private equity firms) is surely an indication of the fear of a hedge fund getting their hands on it, and yet another sign that the borrower is still king in the liquid and overcrowded debt market.
Most of the time, a private equity firm can have little or no control, even with consent reasonably withheld – it can be quite tricky for a borrower to argue its corner in cases where it doesn’t want a certain institution owning its debt – a bank that is really an investment fund is one example where a borrower could legitimately withhold its approval.
A distressed situation is one which obviously all private equity firms want to avoid, but which many are prepared for in the coming years. What LPs want is for GPs to have some control over the situation. It is an issue which they are aware of and keeping a close eye on, which is understandable. But it is unlikely that any serious private equity limited partner is going to go unscathed should the market take a dive. Hedge funds in particular are a worry for LPs, which see their increasing involvement in debt trading as a threat to their potential returns.
Andre Jaeggi, managing director at fund-of-funds manager Adveq, emphasises the need for control over the syndication process. The firm itself shies away from investing in funds that focus on leverage buyouts, preferring to target funds that invest in equity. However, leverage remains an important part of the deals that Adveq’s funds invest in, and Jaeggi is worried about debt being “syndicated away without any say from the equity shareholders. Equity providers need to be more careful. In the rush to get deals done they rush through their due diligence, leading to a lack of control over where the debt is going. It is an additional element that needs to be examined. As a fund-of-funds, we check which managers do this before deciding whether or not to invest with them.”
Unfortunately on the bigger deals, that is always going to be the case. When a private firm is involved in a mega-deal, it really can’t start throwing its weight around and saying who can and can’t hold notes. Should private equity firms know who owns their debt? Certainly. Should they care? Yes, because if things go sour, these are the people the funds are going to have to sit down and negotiate with. How much control a firm can work into its covenant depends, ultimately, on how big the firm is. Hugh Briggs, a director in CVC’s international team, said in a workshop at the EVCA Symposium in June, that “if you are a large European syndicated you can basically have complete control over who is in your syndicate by telling the investment banks.”
When the transaction is complete, the situation becomes much more difficult. Briggs said: “Once the deal is done you have you have less control and if it’s a €5bn deal or higher then you have got no control. The smaller a deal the more control you can have.”
The threat of hedge funds can be overplayed however and there have only been limited reported examples of hedge funds proving to be difficult debt holders in distressed situations involving a private equity backed business. Depending on the individual hedge fund’s strategy, it’s perfectly plausible its interests will chime with that of the borrowers. In this sense, hedge funds have been both a friend and a foe to private equity because while their entry into the debt space has increased liquidity and driven down debt pricing, they have also the potential to make life difficult by refusing to agree to a restructuring plan that does not fit in with their return strategy (private equity firms also accuse hedge funds of being far too inflexible, making the whole process longer than it needs to be).
James Dinan, founder & CEO of York Capital Management, a US$8bn hedge fund, speaking at the same workshop as CVC’s Briggs, said: “Most people are quite rational. They are trying to rationalise their piece of the pie. Rarely do you get someone who is trying to be destructive. A debtors’ views will be different depending on where they are in the capital structure, and you can get big fights over this. What often happens is the management takes a side.”
Borrowers have a range of weapons open to them to help defend themselves against secondary debt trading they perceive to be potentially troublesome in a distressed situation. One is ‘yank the bank’, where, if the borrower has secured consents to specific amendments exceeding two-thirds of the loan by commitments, it can prepay any institutions that are holding up the process. Another is the ‘snooze and lose’ clause, which requires lenders to respond to a borrowers’ restructuring plans within a certain amount of time and in which a non-response within that time frame is regarded as consent. A third protection is the ‘equity cure’, which allows the private equity firm to inject more cash into a company that is close to defaulting.
Videon is not convinced any of these devices can offer genuine protection in a distressed environment. She says: “If you are in a distressed situation in a negative economic environment then these things would really hurt you because the market will just price your debt according to the market.”
Of course, it should be made clear that secondary trading can sometimes prove to have a positive bearing on a restructuring programme. A good example is the case of Ihr Platz, a German drug store chain. In 2005 it was approaching insolvency until Goldman Sachs took control of the company’s €110m debt and sent in US turnaround specialists Alvarez & Marsal, and when the other lenders refused to play ball Goldman just bought out the remaining debt.
In practicality there is little a borrower can do to restrict who its debtors are. The first is the credit default swap, which is mainly the concern of the bigger buyouts. The second is silent sub-participation. Nick Soper, a director of UK investment banking at Investec, recently of KPMG, explains: “Effectively, the original lender remains the lender of title (the party that the borrower is aware of), but the credit risk of the loan, and the margin/fees, transfer to the sub-participator. More importantly, the making of any decisions/permissions required under the loan agreement moves to the participator with the original lender required to vote accordingly in bank decisions – this is clearly worrying if things go bad and decisions can be against the borrower.”
The borrower never has any knowledge of this and there have been instances where a borrower has been perplexed by a once reliable debt holder voting completely illogically.
Soper makes the point, that, ironically demanding more control can actually mean private equity firms end up with less: “The fiercer the private equity borrower is about debt trading, the more likely it is that the banks will resort to these sort of things.” In short, if a bank decides to use one of these mechanism, pushing for absolute consent could mean nothing.
A further issue to take into account is the rise of the use of CDOs and CLOs, which represent a significant portion of the debt market. CDOs and CLOs are made up of a broad spread of notes by banks and sold to institutional investors. These investors could be a problem because they may not really understand private equity or have much interest or be much help in a distressed situation.