Europe’s LBO Financing Markets

Last year was yet another landmark year for Europe’s leveraged finance market, with the volume of deals, investor liquidity and structural aggression surpassing even the substantial records achieved in 2005. LBO financing volumes have rocketed to all-time highs, with unprecedented deal flow across the senior debt, mezzanine, second lien markets and high-yield bond markets. “In volume terms, 2006 was the best ever year for European leveraged finance – the market has defied expectations to deliver even stronger deal flow than in 2005,” says Hamish Buckland, co-head of European Leveraged Finance at JPMorgan.

According to Standard & Poor’s LCD, total LBO loan volume from January to November was €114.1bn from 239 deals, up from €103.7bn and 192 deals for all of 2005 and just €44.12bn and 119 deals in 2004. The subordinated debt markets have deepened even more significantly. Mezzanine volumes also swelled to an all-time record, at €11.9bn, up from €5.06bn in 2004 (Standard & Poor’s LCD), as did high-yield, with US$36bn in issuance, up from US$23bn in 2005, US$18.2bn in 2003, US$4.9bn in 2002 and US$9.2bn in 2000, according to Thomson Financial.

Mid-market transactions dominated deal flow, especially in the second half, but there were also a number of high-profile, jumbo LBO financings. Q1 kicked off with two major deals agreed in 2005 – the €12.225bn financing backing the ground-breaking buyout of Danish telecom group TDC (Europe’s largest-ever LBO) and the €9.9bn debt financing supporting Ineos’ purchase of BP’s petrochemicals division Innovene.

Other headline deals that followed included the €8.7bn public-to-private of Dutch media group VNU, the £8.97bn public-to-private financing for airports operator BAA, the €6.4bn buyout of the Netherlands-based Philips Electronics’ semi-conductors division (mainly financed by a €4.5bn high-yield bond – Europe’s largest-ever offering) and the £8bn purchase of water utility Thames Water.

Volumes were further boosted by a number of cross-border syndications emanating from the US – mostly notably the landmark US$33bn buyout of HCA in July, which finally surpassed the US$31bn RJR Nabisco’s long-held record as the world’s largest buyout.

Yet 2006’s buyout bonanza was only possible because of the immense liquidity prevailing in Europe’s leveraged finance markets, which vastly extended the limits of what private equity firms have previously been able to buy.

Debt investor demand has been extremely high for the past few years, but it ballooned even more radically in 2006. Traditional lenders, such as banks and the older CLOs remained keen investors, but had to contend with yet another huge wave of new funds piling into the market with even greater force and determination than in 2004 and 2005.

Indeed, this ever-burgeoning institutional investor base has been the main component driving debt market liquidity to such unparalleled levels. Investors such as hedge funds have found it hard to make money in today’s bullish high-grade debt and equity markets, so have diversified into high-yield. The relatively good security and protection in LBO financing, the still very low default rate and the swiftly maturing secondary markets have proved further enticements. “Many traditional public equity and high-grade debt investors have piled into Europe’s leveraged finance markets, due to the dearth of attractive investment opportunities elsewhere in the last two years,” says Richard Howell, co-head of leveraged finance at Lehman Brothers.

The CLO boom in particular has been fuelled by technicals, as investors have moved from public equities into structured fixed income. “It is still very easy to raise debt cheaply for CLOs. This has driven the huge levels of demand for these vehicles,” says JPMorgan’s Buckland.

To boost their buying power and increase their flexibility, older European CLO managers such as Alcentra, Avoca, Babson and ICG have diversified, creating low levered funds, pro rata vehicles and open-ended market value and credit funds, as well as continuing to price traditional cash-flow arbitrage CLOs. New indigenous CLO managers, such as CLO Management Europe, New Amsterdam Capital and Elgin Capital emerged with debut vehicles, while more European banks, including Calyon, IKB, KBC and SG CIB, plus European-based hedge funds such as Cheyne Capital and CQS, also launched inaugural CLOs.

Even more notable, however, was the invasion of funds from the US, spanning US CLO managers, credit and hedge funds and prime rate funds. With European LBO financings priced at a significant premium to those in the US and offering investment diversity, Europe has proven to be an exciting new prospect for US managers. Black Diamond, Deerfield Capital Management, Eaton Vance, Golden Tree Asset Management, Lightpoint Capital and Oak Hill Advisors are just a few of the many US CLOs and hedge funds to launch debut European CLOs in 2006.

Institutional investors have now reached critical mass, accounting for half of the primary senior debt market, with a market share of 48.8%, compared to 25.2% in 2004 and just 4.21% in 1999 (according to S&P’s LCD). Anecdotal evidence suggests funds’ share of the secondary market is already well over 50%.

Even with 2006’s healthy LBO volumes, demand from investors outweighed the supply of deals and competition for debt was cut-throat, ensuring the markets remained stuck on over-heat all year. The high-yield market did suffer a few months of turbulence from mid-May, as a result of equity market volatility following concerns about interest rates and inflation and the impact of these on global growth. This had a muted, knock-on effect on the secondary loan market, where prices fell from their all-time peak of 101.18% of par in the week of 11th May (S&P’s LCD) to below par. However, the volatility proved short-lived and by Q3, both the high-yield and secondary markets had more than recovered their poise. October saw the largest-ever bond, for Philips Electronics’ Semi-Conductors – Europe’s largest-ever offering – and in November, average secondary loan break prices nudged above the 101 mark once again.

The rest of Europe’s leveraged finance markets remained utterly unscathed by the mid-year blip, with most senior, second lien and mezz syndications drawing massive oversubscriptions. The resulting drastic scale-backs on allocations by arrangers left most investors even more desperate for paper.

Demand drives structural aggression

Amid such intense liquidity, the aggressive financing structures already seen in Europe over the previous few years of this current bull market were stretched even further in 2006.

Structures were pushed way past previous limits in every way, forcing those that had already called the top of the market back in 2005 to have a rethink. With credit quality deteriorating amid sky-high debt levels, talk of the LBO bubble and an inevitable rise in future defaults, which originally surfaced back in 2004 when the markets first started to over-heat, went into overdrive.

Leverage levels soared way over the previous market peak of 1998-1999. 36.8% of LBOs were leveraged over 6x EBITDA, compared to just 12.9% in 2004 and 12.5% in 1999. Purchase price to EBITDA multiples rocketed to a staggering 9.4x EBITDA in November, up from 8.31x in 2005, 7.56x in 2004 and well over the 8.16x seen in the previous market peak, in 1998 (S&P’s LCD). “Unprecedented investor liquidity this year has resulted in the most aggressive LBO financings ever seen,” says Lehman’s Howell.

Not only was far more debt applied to businesses, but there was a more emphatic move away from amortising debt, with arrangers structuring back-ended facilities with inflated bullet repayment B and C tranches and far smaller amortising A tranches. In several instances, arrangers scrapped the amortising tranches altogether.

Traditionally, LBO financings have started to repay debt as soon as possible. Back-ended deals alleviate repayment pressure in the crucial early post-buyout years, allowing the sponsor to heap on far more leverage. For investors, back-ended deals remove crucial control and financial security. As debt is stored up for repayment in a big lump sum towards the end of the financing, there is a real danger the company will be unable to repay so much at once. “Back-ended deals have become the norm, despite the refinancing risk they entail. As a consequence, investors have less covenant control via scheduled amortisation than in the past,” says Lehman’s Howell.

Yet alarmingly inflated debt was not the only form of structural aggression that investors had to grapple with. All-senior deals really took root in 2006. Providing the sponsor with the cheapest possible funds by removing the expensive subordinated debt below, all-senior deals require investors to give up their security cushion. AVR Waste Management, Elior, MTU, Phones4U and Picard Surgeles were among the year’s many all-senior deals, although investors did baulk at the most audacious one in November – Nycomed’s €5.7bn jumbo. That deal ultimately had to be restructured, with a €425m second lien added, to attract sufficient support.

Meanwhile, PIK notes and loans – the hallmarks of a bull market – resurfaced in 2006.

Brake Bros, Eircom, KDG, New Look, TIM Hellas, Weetabix and Wind were among the many firms to issue PIK notes or loans, to pay dividends or repay more expensive debt. This riskiest form of leveraged finance was snapped up by hedge funds in particular.

Another major barometer of the ultra-aggressive lending climate was the extent to which reverse flex – encompassing both structural loosening and spread reductions – pervaded the market. After successful syndications, many sponsors took the opportunity to cancel some or all of the more expensive sub-debt tranches, increasing senior term loans instead. The influence of the US through cross-border deals and those US investors migrating to Europe was a contributory factor both to daring reverse flexes and the very low launch spreads that emerged, with some arrangers moving to a book-building approach to pricing.

No sooner had 250bp and 300bp on the B and C term loans become the market norm for most deals, sponsors started pushing for even lower levels, 175bp to 187.5bp on the A and revolver, 225bp to 237.5bp on the B and 275bp to 287.5bp on the C was seen on a number of deals. In November, Iglo Birds Eye was the subject of one of the most comprehensive flexes yet seen in Europe, with the B slashed to just 225bp, the C to just 262.5bp, the mezz by a hefty 125bp to just 8% and the second lien entirely removed, with the B and C upped accordingly.

Mezz spreads fell even more notably, as hedge funds such as Apollo, Eaton Park and Och-Ziff continued to swarm into the asset class and CLO managers such as Avoca and Babson Capital closed substantial mezz funds. These new mezz market entrants heaped yet more pressure on traditional mezz funds and CLOs trying to fill their mezz buckets. Average mezz pricing fell to just 937.6bp in the three months ended November 2006, from 964bp in 2005 and 1029.7bp in 2004 (S&P’s LCD). Many deals radically undercut these averages, as with Weetabix’s warrantless mezz in February, priced at just 7.75%.

Perhaps the best barometer of the aggressive climate was the secondary market. As many funds were unable to access primary syndications due to so much competition, many were forced to buy in secondary, pushing prices up to record highs. Throughout 2006, the B and C tranches of many LBO credits traded up to 101.5 to 102 or above.

Yet for many bankers, the most alarming example of structural aggression was the pervasive and determined loosening of financial covenants and documentation. To give credits financial flexibility and alleviate the risk of default, investors have been forced to accept looser and looser financial covenants, protection-lite transactions and, in some cases, less information and due diligence.

Covenant headroom rose sharply, while sponsors routinely used disposal proceeds to pay dividends, rather than debt. Thus, not only have lenders taken on far more risk for far less reward, but they have been giving away their protection too.

Warning signs broadly ignored

Although many investors were willing to accept such aggressive deals, there was however a solid band of investors that complained vociferously about 2006’s structures, pointing to the warning signs of an over-heated market and forecasting a rash of defaults. The more zealous harbingers of doom now predict a return to the meltdowns seen in early 1990s, especially if the economy slows and interest rates keep rising.

Although Europe’s leveraged finance default rate is still very low, the number of debt restructurings and covenant waivers to ease repayment pressure did rise noticeably in 2006. LBOs in sectors such as automotive and, with the price of oil rocketing above US$70 a barrel at one point, chemicals and other related industries came under particular pressure. For example, auto-parts maker TMD Friction tapped the market for a restructuring facility in November, after seeking a waiver on its senior debt in June while it renegotiated a debt-for-equity swap with mezz lenders. There was even a high-profile default, with Global Automotive Logistics filing for creditor protection in May.

Spooked by the state of the market, many banks and older CLOs started to decline more deals as the year progressed, signing up only to the more familiar or strongest transactions. This, and the fact that the odd deal did have to be flexed up, prompted wishful thinking in some quarters during and after the summer that the long hoped-for market retrenchment had finally begun.

However, ultimately, this proved to be far from the case, as overall market liquidity continued unabated right through till year-end. Unlike in past years, the absence of traditional investors from a syndicate did not automatically spell syndication disaster – indeed in many cases, quite the reverse. Apart from a few particularly over-blown transactions – such as FCI (Framatome), German Media Partners, House of Fraser, Numericable, Tarvalon Versatel, and VNU, which endured difficult syndications, closed long or had to flex up or restructure – the vast majority of 2006’s highly leveraged deals syndicated extremely well, irrespective of whether traditional lenders supported them or not. There were simply too many other investors waiting in the wings.

These other investors took comfort from the fact that 2006’s waivers were localised events limited to specific sectors, such as autos, rather than a systemic market-wide risk. “Most people’s portfolios remain in good health and the default rate is still very low. The market is aware it is storing up trouble for the future, but we haven’t seen it yet and until we see it, investor liquidity will continue at the current highs,” says JPMorgan’s Buckland.

Although traditional lenders remained very much in the market for the right deal, in those deals they declined, the syndicate composition merely evolved past them, with arrangers selling more and more to first-time accounts. “In the last quarter of 2006 in particular, syndicate lists changed a lot. Typical LBO lenders declined far more and were replaced by the new fund entrants, especially US CLOs,” says Vijay Rajguru, head of loan syndicate at Barclays Capital.

No end in sight?

Going into 2007, overall market liquidity shows no sign of faltering. Concerns about debt levels may be endemic, but funds’ appetite is as voracious as ever.

Yet, as with every cycle, the bull market will end at some stage and liquidity will fall from its current record highs. The eventual cause of this, however, is no longer expected to be a single leveraged finance-limited event, as the market has already shrugged off a couple of defaults and failed syndications without blinking.

Instead, only a big external financial event or widespread outbreaks of LBO defaults are now deemed likely to jolt the market onto a more conservative plane. “In the past, it has always been said that one big failed syndication or default would turn the market, but this is no longer true. There’s always someone now who will buy paper for the right price, so people have an escape clause. For market conditions to really cool, it would take a more seismic, external financial event now,” says Barclays’ Rajguru.

Only when general economic conditions deteriorate and companies start underperforming across the board, will investors become more risk averse. Given today’s back-ended capital structures, most LBO credits have quite some time before repayment dates kick in and, although they are extremely levered, most have significant headroom protection before they hit against their covenants. Thus the general consensus is that this correction is still some way off.

To the dismay of many, therefore, barring an unforeseeable wider financial shock, Europe’s leveraged finance markets are expected to continue in their current bullish vein until 2008 at least. “The downturn is not expected in 2007, which will be just as strong as 2006. Portfolios are still in good shape and Europe’s economic outlook looks reasonably robust. Also, today’s deals have very patient capital structures, with lots of headroom and limited amortisation, so it is harder to default on them,” says JPMorgan’s Buckland.


Institutional investor demand drives structural innovation

As well as aggressive financing structures, institutional investor demand continues to drive structural innovation and the creation of new products and syndication strategies in Europe.

Arrangers are structuring further and further away from the bank market, tailoring deals for the fund community instead. Funds are not only cheaper to sell to, given their willingness to accept zero upfront fees and lower spreads, but they also reply far quicker than banks and are often less discriminating about credit quality, covenants and the level of information they will accept.

2006’s financings were peppered with second lien and high-risk PIK notes, both of which are relatively new, fund-centric products. Second lien first appeared in Europe in 2004, but has swiftly become an entrenched market feature. Sitting between senior debt and mezz in the capital structure, its combination of implied senior status yet higher spreads is particularly attractive to funds. Meanwhile, PIK notes – the riskiest form of LBO debt that sit right at the bottom of the capital structure as quasi-equity – re-emerged in 2006, targeting the hedge fund community.

European LBO financings are increasingly evolving towards the US model, in both structure and syndication composition. Arrangers are carving out more and more of the lucrative B and C term loans for funds. Whereas previously arrangers saved 50% of these tranches for banks, funds are often now claiming the lion’s share. For example, Materis, TdF and SSP all had 70% fund carve-outs on the B, C and second lien.

Banks in Europe now fear 2007 will see an even firmer move towards US-style structures, where banks are routinely blocked from B tranches and invited only into the pro rata revolver or amortising A tranches. A few such cases have already emerged – Brenntag locked banks out of its B loan early in the year, while in November Orion Cable only invited banks into its A and revolver, saving the B, C, second lien and mezz for funds.

In addition, the trend for back-ended debt was taken to a new level in 2006. There was a host of bullet-heavy deals and even some all-bullet, US-style B and revolver-only transactions. Not only does the absence of amortising debt allow sponsors to heap yet more overall debt onto a transaction, but they also appeal directly to funds, many of which are still unable to buy amortising debt.

Elior’s take-private in May was financed with all-bullet senior debt, as were the deals for Kettle Foods and Travelodge Hotels in October. In November, TNT Logistics emerged with a B and revolver-only structure. Many now predict 2007 will see the gradual disappearance of C tranches, to further mimic the US B and revolver-only standard – with United Biscuits in December an early precursor of this. Not only did it launch without an A tranche, but a post-syndication structural flex removed the C, folding this debt into the cheaper B tranche instead.

Arrangers are also appealing to the fund community with new syndication strategies. Although traditionally, funds have been invited into transactions in general syndication, some deals are now launching to the bigger ticket-buying funds even before banks are approached to sub-underwrite – as was the case with Doncasters in February.

As funds have a far quicker internal approval process than banks, they are able to respond more rapidly to syndication invitations. Arrangers have therefore also started insisting on far swifter deadlines for all lenders – as seen with syndications for FCI, BSN Medical and Orangina. This is anathema to banks, which require a certain time frame in which to receive credit committee approval. More than one bank has been locked out of a transaction for replying too late in 2006 as a result of this new trend.

With institutional investors already accounting for half of the primary market in Europe, banks are in danger of being marginalised in 2007. Many predict funds will rise to supremacy by the end of the year, with a primary market share estimated, at the most conservative count, at 60% by then. “Banks’ share of the market will continue to fall in 2007. Europe’s LBO financing markets are moving inexorably away from the bank-driven model towards institutional investors, following the US blueprint,” says JPMorgan’s Buckland.