Deep in debt

A few short years ago, most private equity houses looking for acquisition finance for their deals went to a handful of banks they had good relationships with plus perhaps one or two mezzanine players, negotiated a decent debt package and that was pretty much the end of the story for a few years.

How things have changed. The last three to four years have seen an explosion in the number of players offering leveraged finance. This has been driven by some very attractive fundamentals. “Yields on senior loans have been very attractive for a while now, margins have held up well and there has been low volatility,” says Zak Summerscale of Babson Capital Management. “Investors are very keen on investing in this area.” In turn, banks now increasingly see their role as arrangers of debt syndicates rather than actual lenders.

Some statistics will put this into perspective. In 2000, European banks held nearly 68% of the senior debt going into buyouts in Europe, with just 7% held by institutions, such as CDOs, CLOs and hedge funds, according to Standard & Poor’s figures. Last year, the figure was 38% for banks and 50% for institutions. Taking into account the enormous growth in the debt market itself over the last few years – S&P figures show that total LBO loan volume from January to November 2006 alone stood at €114.1bn in 239 deals, up from just €44.12bn in 119 deals in the whole of 2004 – this increase in market share is “impressive to say the least”, according to Paul Watters, head of loan and recovery ratings, Europe, at S&P.

These changes have not just been driven by the sheer number of new CDOs, CLOs and hedge funds, although adding hundreds of new funds to the European debt landscape has certainly played a large part in them. The way in which these funds access capital is also partly responsible. “It’s clear that when you look at the market today, there is a huge amount of liquidity,” says Rolf Nuijens, investment director responsible for mezzanine in Germany and Benelux at ICG. “Most of the capital is sitting in CDOs and hedge funds. The way in which these entities are structured means they have to invest. They are highly leveraged and so holding cash on the balance sheet is costly for them – they have to find a home for it, even if it’s only for the short term.”

This pressure to invest, together with the sheer weight of money going into the debt markets has resulted in something of a windfall for private equity sponsors – in some respects, at least. “Private equity houses are able to target much larger deals now than they would have done just two or three years ago,” says Nathalie Faure Beaulieu, managing director at European Capital. “There is so much more liquidity in the debt markets now with the entry of new institutional money that the structures being put in place are more refined and tailored to each specific deal. This has reduced the cost of financing deals.”

Summerscale agrees: “Liquidity in the market such as we’re seeing improves private equity houses’ economics. Their cost of finance has reduced and so they are able to pay higher prices for assets. There are deals that have been done over the last few months that would never have been done even a year ago.”

Together with the huge amount of capital going to private equity fund raisings, the ready availability of debt has brought about several successive record-breaking years in terms of buyout deal values. We’re closer now than we ever have been to the speculation of a FTSE 100 company going private becoming a reality.

The seemingly never-ending demand for paper has allowed – at the large buyout end, at least – firms to decrease the amount of equity they put into deals. In 2002, the average capital structure in a leveraged deal was 55.2% senior debt, 12.2% junior debt and 32.6% equity, according to Fitch statistics. By 2006, the equity portion had reduced to below 30%, senior debt had increased to around 58% and junior debt to nearly 14%.

Structures have also become more complex, with some of the larger deals now featuring seven layers of debt. Part of this is the result of the popularity among investors of the non-amortising B and C bullet tranches, which are being put in place at the expense of the amortising A tranche. “There is a lot of appetite for bullet tranches as these are more suited to the needs of investors matching liabilities,” says Nick Soper, head of Investec’s debt advisory arm. “As a result, amortising tranches are lessening in many deals and in some cases disappearing altogether.” As with most trends in the debt market, the move towards bullet-only senior debt started at the larger end of the market, but it has been trickling through to the mid-market. HgCapital’s recent £190m acquisition of fashion business Americana from Isis Equity Partners involved around £100m of debt financing. Only £20m of that was amortising, according to Hg’s Ben Hewetson. “We are also about to announce another deal at around the £100m mark that is bullet-only,” he adds.

This back-ending of repayment schedules, together with the increased use of second lien and PIK notes, means that some private equity-backed businesses may not have to repay debt for up to six years. That clearly gives firms much more scope in what they can do to grow a business, given that cash flow is less constrained than it might otherwise have been.

Demand for paper is also clearly leading to some very aggressive structures – and practices – among some of Europe’s largest buyout houses. “I’ve recently heard of one deal at the large end that is bullet only and there are no covenants,” says one market observer. “So the only incidence that will trigger a default is the company not being able to pay the interest charges on its debt, and even then, the company has the option to convert the debt to a PIK note. That is horribly aggressive and I’ve never seen anything like it before.”

Some firms have also taken advantage of institutions’ current appetite for senior debt at the expense of more costly junior debt, much to the consternation of some in the market. The first example of this was Cinven’s refinancing of French cable group Numericable earlier this year, through which it managed to replace €500m of mezzanine and €250m of second lien with €800m of senior debt. This deal was considered as particularly aggressive, especially as the debt for the original deal done last year had proved hard to sell.

But this isn’t the only example of structural flex seen in recent times. KKR recently replaced €300m of mezzanine financing with senior debt in its buyout of Kion. Other deals that have seen this happen recently include Orangina and United Biscuits, according to Fitch. Some of this has to do with the way that banks are arranging debt. “In some cases, we have seen banks adopting a bond market-style book-building approach in syndication,” says Soper. “Structures have flexed towards senior debt where high demand has been seen. Borrowers will naturally go for cheaper senior debt if they can get it, squeezing subordinated debt out of overall packages.” And that only makes for more demand among the players that have been elbowed out. “The trend for flexing means that there is overspill in the mezzanine market,” says Nuijens. “The ones that missed out on a deal that got flexed then try and find other opportunities, so the demand for mezz increases by quite some way. Some of the large deals that have been flexed were pretty good stocking-fillers for the CDOs.”

Along with the availability of cheap debt has come a weakening of terms that accompany that debt. Documentation has become increasingly borrower-friendly as covenants have become looser – and in one or two cases so far – non-existent. A whole new lexicon of clauses has emerged, with some of the terms trickling steadily into the mid-market from larger deals. ‘Mulligan breaches’ allow businesses to breach their covenants at least once without triggering default, for example. ‘Toggle notes’ have also crept into the market – these enable companies to turn off the cash coupon in mezzanine structures so they pay interest exclusively in notes rather than cash. ‘Equity cure’ has almost become the standard, in which private equity firms can inject more equity into the business to prevent default. ‘Yank the bank’, which allows sponsors to replace a non-consenting minority lender in a deal and ‘snooze and lose’, which effectively gives creditors a time-limit in voting on proposals, are two other common terms written into documentation these days.

Not all have become market-wide standards, however. “The liquid markets are enabling larger private equity houses to negotiate some very favourable terms,” says Faure Beaulieu. “But I don’t think this is filtering through too much into the mid-market, where the companies are more susceptible to a downturn and where terms are fairly similar to what they used to be. We look at this issue very closely and obviously, we’d prefer to have tighter terms where possible, but we look at the strength of the credit and decide whether or not it is appropriate to have looser documentation. If it isn’t, then we’ll pass.”

But it’s not just on new deals that private equity houses have been able to benefit from liquidity in the market. Refinancings made up 51% of the leveraged finance market last year, according to Fitch. For a number of years now, firms have been refinancing portfolio companies to pay themselves dividends and recoup some or all of their investment while still retaining their stake. This is set to continue while market demand remains strong. “There will continue to be a strong focus on recapitalisations,” says Simon Tilley, director at Close Brothers Debt Advisory group. “Private equity groups, many of which have raised significant funds in the last year or so, don’t need to sell businesses right now to support fund raisings. So they will recap a business to de-risk the asset and take money out.”

But there are other, more strategic ways of thinking about recaps. “Some are using an alternative financing technique – such as an opco/propco structure – to re-position a company’s capital structure to drive additional value ahead of a sale process,” says Tilley. “Refinancings are also being done to take advantage of pricing compression in the market and to bring loan documentation up to date.”

Yet there are negative aspects to such readily available cash. The primary downside is that liquid debt markets, coupled with recent stellar private equity fund raisings, have pushed asset prices up, with some areas affected more than others. “We’ve seen an increase in debt multiples going into all but the smallest deals,” says Iain Purves, head of acquisition finance at Bank of Scotland. “At the larger end, this is squeezing the equity cushion, which has fallen from around 30% a few years ago to closer to 25% now. In the mid-market, however, those multiples are going straight onto the price.”

It’s a trend noted by Hewetson, too. “There is no doubt that the current conditions in the debt market have contributed to pushing up prices,” he says. “We’re seeing some very B-grade assets going for A-grade prices.”

And all this ultimately puts pressure on returns. “With less amortising debt being put into structures now, the vast majority of credits now have no stress on their cash flow,” says Faure Beaulieu. “But all these deals will have to be refinanced or sold at some point. If you’re buying at multiples of 12, 13 or even 14x and putting in debt of seven or eight times EBITDA, then you have to sell the asset at a much higher price to generate the returns you’re looking for. You have to work that much harder to create value in these deals.”

With no sign of let-up in institutional demand for paper – many advisers say the pipeline of new CDO and CLO funds remains pretty full for the foreseeable future – structures and terms look set to remain aggressive and could become still more borrower-friendly throughout this year. As a result, we’ll continue to see larger deals being done and there could be some spectacular exits via secondary buyout to come. But over the longer term, it may be that the higher prices being paid now drag down returns in the future, especially if liquidity dries up for any period of time. Few are willing to speculate on this. There is one thing everyone seems to agree on: the institutionalisation we’ve seen in the debt markets is here to stay.

And if it all goes wrong?

The rapid institutionalisation of Europe’s debt markets has clearly helped private equity firms do many deals that they might not have been able to do a few years ago. Deep and liquid debt markets have provided cheap and flexible capital. But the good times are unlikely to last forever. History shows that, as with almost any market, appetite for lending is cyclical.

To a certain extent, some of the cyclicality has been removed by back-ending of repayment schedules and looser covenants, but there will come a time when companies need to repay their debt or refinance. If market conditions have changed by then, some will find life rather tougher. “Default rates today are superficially low,” says Rolf Nuijens of ICG. “Many underperforming assets are able to refinance and postpone dealing with their problems. That, together with the back-ending of repayment schedules means that we are simply delaying an increase in defaults. We will see this happen, but it will take longer to become visible than previously.”

As for what could trigger a change in market sentiment, it’s anyone’s guess, but it’s unlikely to be a single large default as we’ve seen in the past. There are now too many players interested in buying paper at below par. When hedge fund Amaranth was forced to sell off US$2bn in loan assets last year because of bad bets it had made in the natural gas market, the secondary market simply bought up the entire lot a single day. But there are other factors that could come into play. “Liquidity may dry up for any number of reasons,” says Nuijens. “It could be something happening in the wider economy and in which case we may see several Amaranths in one go: the recent stock market decline saw a weakening of PIK note trading, for example. Or it could just be that hedge funds decide to look elsewhere to find attractive returns.”

So what of companies that get themselves into trouble? How will the new credit landscape affect their attempts at getting back on track? The truth is that no-one really knows because the market is so new and hasn’t seen a downturn yet. In some ways, the rush of new entrants could work in companies’ favour. “There is a significant amount of money available to support new leveraged deals, but there is also a lot trying to find a home in stressed or distressed opportunities,” says Alan Hudson, of Ernst & Young’s restructuring team. “The market is so liquid at the moment, it offers companies facing difficulties the ability to refinance, with borrowers and lenders able to find replacement debt providers fairly readily.”

Even if the wider debt markets dry up, these investors will still to have an appetite for more difficult situations – although at a price that may not be to private equity houses’ liking. “Some may well have a loan to own strategy and be seeking a debt for equity swap – which clearly may not be in the interest of certain other stakeholders,” says Hudson. “Others may buy in at a particular price as they believe there is potential for a default or other event which will require their agreement and which will be withheld unless they’re offered a deal that improves the value of the debt they hold or they are bought out at a higher price than that on which they traded in.”

Yet even before the stressed/distressed investors get involved, the process of rescuing a troubled company will be made that much harder by the complex layers of debt and the sheer number of people involved these days. “This time around, for larger deals involving any number of counterparties, achieving agreed restructurings becomes harder,” says Nick Soper of Investec. “It’s not easy to get lender consent to a course of action if you don’t know who you’re dealing with. You also might not know what each party’s motivation is because you don’t know at what price they traded in. It all adds to the overall complexity.”

As a result, many firms have sought terms preventing debt trading. In reality, though, these are pretty blunt instruments against market forces. “In the past, private equity houses have tried to restrict the sale of paper on the deals they did,” says Robin Menzel, partner at Augusta & Co. “But I think they now realise that is detrimental because it just means that they don’t know who their lenders are when it is sold on. Restricting trading just forces it into secrecy with so-called silent subparticipations.” Besides, there is little they can do to prevent secondary trading of paper – lenders will always insist on their right to be able to do this.

Yet there are some that believe the scare stories of institutions playing hard-ball are over-played. Menzel is one. “The talk about hedge funds being difficult in the event that a company underperforms is often wildly exaggerated,” he says. “Lenders are co-operative out of necessity. They have to work together to fix a situation. Consequently if a fund suddenly stepped in and tried to convert debt to equity at the first sign of trouble, no-one would want to work with them again. Private equity should not fear distressed investors: they are often more experienced in the new financing and legal techniques and far more motivated to find a quick and workable solution, so they can move on to the next situation.”