The emergence of deal flow statistics for the first quarter has confirmed what Europe’s loan bankers have been fearing since the start of the year. In the year to March 31, the number of sponsor-backed loans dropped to 50, compared with 67 in the same quarter of last year, according to figures from Thomson Financial.
Moreover, only the final quarter of 2005 generated fewer deals, at 48, with the second and third quarters generating 66 and 59 respectively. Although the second quarter has started fairly well by adding another 12 deals to the tally, the question now is whether the slow start is a blip, or if the leveraged bonanza is finally running out of steam.
There are numerous possible reasons for the dip in deal flow. One of the strongest influences working against sponsors is the rallying of global equity markets, which cuts to the heart of the traditional private equity business model of seeking out undervalued companies, taking them private, and re-floating them later at a profit. While the stronger IPO environment is good news in terms of exits, fresh deal flow is the lifeblood of the industry, and crucial to any portfolio approach.
Edward Eyerman, managing director at Fitch Ratings said: “Boards are becoming less receptive to private equity bids as share prices recover. They do not want to sell out too cheaply.”
The disillusion caused by low public valuations since the dotcom crash may not have been enough to prompt a delisting, but it at least made boards more open to an approach from sponsors. Hostile take-privates now verge on the impossible.
For those boards still amenable to an approach at this point in the cycle, a savage response from institutional investors awaits, as demonstrated by the recent remonstrations by Knight Vinke Asset Management against consortium-backed vehicle Valcon Acquisition’s offer for VNU.
Moreover, sponsors may be beginning to rue the triumphant headlines of the past year, which have widely publicised the larger fund sizes that sponsors command. The impression of having deep pockets is a difficult one to shake. One source at a private equity firm said this week that the competition for deal opportunities combined with the size of funds requiring a home was beginning to have an impact.
The reduced deal flow can also be explained by the drop in secondary and tertiary buyouts that formed such a large element of last year’s market.
“Leverage markets are not exceeding the [leverage] limits they set in the third quarter of 2005, which makes it hard to recycle LBOs,” said Fitch’s Eyerman. “While we may still see attempts to test these limits, senior and total leverage has certainly flattened out in Q4 and Q1.”
This flattening has come despite the continuing availability of cheaper debt, particularly from institutions investing in the subordinate end of structures. “Recycling LBOs is also more difficult when there is less near-term amortisation as these businesses do not de-lever,” Eyerman said.
This highlights the continuing importance of the bank market, which traditionally invests in the amortising A and revolving elements of deals. In recent months, arrangers have been responding to sluggish bank appetite for the more highly leveraged transactions by reducing amortising debt in favour of the bullet repayment B and C tranches.
The extent of this practice appears to have reached its zenith with deals such as Carlyle’s 7.1x leveraged acquisition of IMO Car Wash, where the €350m supporting debt package features a five-year bullet repayment on all tranches.
A third reason for the poorer deal flow in the first quarter may stem from political sensitivities, especially in light of elections in the less mature, from a private equity standpoint, economies of Italy and Germany. Fortunately, this particular influence, in contrast to those already mentioned, is tied to the political rather than business cycle.
With the Italian general election and the German regional elections now out of the way, any protectionist sentiment is likely to play less of a role in the creation of deal opportunities. This development is particularly timely in Germany, where the buoyant M&A landscape offers at least some prospect for fresh buyout activity.
Although the return of trade buyers to the acquisition trail also limits sponsors’ access to new deals, these situations create additional opportunities as the buyer divests non-core assets in order to fund the acquisition or satisfy the requirements of competition authorities. While this guarantees at least some access to fresh deal ideas, the competition surrounding them will be intense, with unavoidable consequences.
“The reality is returns will come down,” said one private equity source. “While 25% is still the target return on investment, we are seeing bids go in where the sponsor can’t be making more that 16%–18% gross on the deal.”
This suggests that the pressure to invest funds, on which the private equity firms charge high management fees, is having an real impact on valuations. If the IRR drops too far, however, the underlying attraction for institutional investors for the asset class will be eroded.
While things may be getting heated, one advantage that the sponsor community still has is its solid grip on fundamentals. As demonstrated by the recent failure of the auction for Fiberweb, which is being spun out of parent BBA group for a target price-tag of £700m (US$1.2bn), the industry is rooted in being able to identify upside. As a result, it is the pipeline, not overall returns, that is likely to give first.