Drive for flexibility

Despite expectations that the early part of the first quarter would be quiet, Grohe’s €800m deal, led by Credit Suisse and Deutsche Bank, means that issuance will be in line with the level seen this time last year, which opened with a €1bn senior notes issue for Fresenius.

And just as that deal defined what was to become one of last year’s trends – M&A finance – so the Texas Pacific Group owned German sanitary products manufacturer Grohe’s effort could herald a series of deals by companies seeking to free up cash that would otherwise by earmarked for amortisation.

There are several reasons why market conditions are favourable for this emerging asset class. The senior secured FRN is not the only way of reducing the burden of amortisation – the move towards predominantly B/C tranches in loan structures also achieves this.

The key difference is that moving to the public markets decreases the frequency with which the company has to release information to its creditors, usually quarterly, as opposed to the constant monitoring associated with a bank facility.

Grohe’s decision has a precedent in NXP, the semiconductors business recently spun out of Philips, which brought three senior secured tranches as part of its €4.5bn jumbo in last year’s final quarter. That deal was also taken to the public bond markets to give the borrower as much flexibility over its capital structure as possible. It seems likely that the NXP deal’s success might have inspired Grohe to follow suit.

The ability to free up cash earmarked for amortisation is especially pertinent in cyclical industries. This is clearly the case with Grohe, as demand for the company’s core products is closely linked with activity in the construction trade, a notoriously cyclical sector.

The increase in flexibility carries significant advantages for Grohe. As the plumbing products manufacturer has plans to invest significantly in new products, it will see an associated increase in its capital expenditure requirement.

Compared with current market norms, the size of the amortising A tranche in Grohe’s bank facilities was quite large relative to the rest of its capital structure, probably as it was put in place before the recent loan market trend of trimming the A tranche in favour of the non-amortising B and C elements.

Timing might also have had a lot to do with Grohe’s decision to refinance now, given that it had a positive run over the last quarter, which was a marked improvement on the rather sluggish tone of the company’s results in the middle of last year.

Moreover, pricing of 287.5bp over on Grohe’s deal is a small premium to the blended yield that would have been obtained through a new bank facility. This coupon is just wide of the 275bp seen on the BB rated euro-denominated tranches for NXP last year, compared with Grohe’s B2/B rating.

While the need for flexibility might have driven the decisions by Grohe and NXP to use senior secured FRNs, it is the threat of rising interest rates that could cause the asset to become ubiquitous.

“The use of senior secured FRNs comes against the background of a global rate rise environment,” said Mathew Cestar, head of European high-yield at Credit Suisse. “The UK raised rates unexpectedly this week and many market participants expect the ECB to hike rates in 2007. In that context, investors prefer a floating rate that will protect principal value. What could present risks to FRN investors would be falling interest rates, which many think unlikely in Europe.”

According to Barclays European high-yield outlook, released last week, the main risks threatening the forecast benign credit environment for high-yield are rising interest rates, possibly driven by attempts to halt a declining dollar, and an associated slowing in corporate growth rates.

While the eurozone base rate appears to be holding steady at 3.5%, the surprise quarter point hike by the Bank of England to 5.25% certainly lends weight to the idea that floating-rate instruments will feature heavily in the year’s issuance.

The seniority of the instrument in the capital structure also plays into the current pattern of demand, especially following the frenzy of PIK issuance seen in 2006.

“The FRN’s secured position in the capital structure makes it low-risk,” said Cestar. “Investors held a lot of risk coming out of 2006 with subordinated products and there is demand to balance that with more senior or bank-like investments.”

As the two assets do not have to come to market at the same time, they fit well with the LBO environment, where sponsors can use the PIK at a later date for dividend purposes.

The shape of Grohe’s 2-1/2 times covered book, which was split evenly among institutions rolling over from the bank debt, hedge funds and traditional high-yield investors, says much about the pattern of distribution the market can expect in the coming year.

“These secured FRNs appeal to both loan and bond investors,” said Cestar. “These types of transactions highlight one of the key themes we see accelerating in 2007 – convergence of leveraged products and investor communities.”

As with all new developments, however, there is cause for caution. While Grohe and NXP can both make a case for using this structure on account of their inherently cyclical businesses, it may not be suitable in all instances.

Rising interest rates create drag on corporate earnings, which can only increase the attraction of reporting on a longer timetable and dispensing with covenants. With the guiding hand of the banks absent, solid credit work with a focus on cash generation will be key to working out which credits to back.