“The European leveraged finance market is slightly less price sensitive than we have seen in some of the other debt capital markets. This is because it is more of a private investor market in that debt tends to be held by bankers in Europe. The tighter pricing on corporate bonds means that any small changes on pricing can have a big effect on the return on capital. With leveraged finance this is not so. Because the price is higher to start with there is not quite the same pressure to increase prices,” says Christopher Rist, managing director, CIBC World Markets Leveraged Finance, Europe.
Although the European leveraged finance market is not as price sensitive as some components of the debt capital markets in the case of buyout financing there are a number of factors about the buyout market and within the banking market that are causing concern among private equity market constituents.
First: the buyout market. Andrew Philips, director at Intermediate Capital Group, who is in charge of the firm’s asset management business, which runs two CDO structures says: “Three years ago we considered the leveraged loan market to be a very unattractive market. Buyouts were generally a lot smaller and we were not convinced that the risk profile for senior debt was particularly attractive and consequently we thought it overpriced. Now the risk profile has improved relatively because deals are getting chunkier.”
Because buyouts have become much larger in recent years the equity component of many of these buyouts has increased considerably. This is partly a function of equity sponsors having a lot more capital to deploy per investment and partly because debt providers have demanded an increase in the equity component of deals.
This gives lenders comfort that the equity sponsor cannot recover if it walks away from the deal. The increased size of these equity-sponsored companies also means the companies can benefit from factors like being able to attract high calibre management and they will find that trade creditors are more understanding because of the sums involved if problems occur. This increased power of many equity-sponsored companies adds up to a reduction in the risk profile of its debt.
Second: the European banking market. “We have seen a reduction in level of competition: it has been noticeably less competitive. This is less price related but more related to a willingness to take underwriting risk. Deutsche, Merrill Lynch and ourselves are probably the most active in underwriting leverage finance deals at the moment. US investment banks are less so,” says Christopher Rist at CIBC.
The pull back by the likes of JP Chase and CSFB can be in part seen in the light of their recent mergers: JP Morgan and Chase Manhattan and Donaldson Lufkin Jenrette and Credit Suisse First Boston, respectively. JP Morgan acted purely as an investment bank and did underwritings for the fees involved and retained little if any on its books. Chase, however, had a large appetite for such paper and market observers note that the JP Morgan approach seems to be taking dominance.
Another factor that market watchers note is that US investment banks are facing the consequences of the tightening of credit markets in the US. This has a knock on effect on their European operations particularly where those operations seek approval from US-based credit committees.
It is also worth noting that a lot of banks are long on cable and telecoms paper because of the number and size of those types of transactions over the last 12 months. They also have history to contend with as Mark Brunault, executive director at mezzanine house Pricoa Capital, points out. “A lot of the banks have long memories, specifically of when things got ugly in the early 1990s. So, the banks have tried to retain semblance of order. Also there has been a lot of consolidation and the absence of the Japanese has made the bank market less competitive.”
Strangely, on the one hand, many underwriting banks contend that syndication is an issue for them and that one answer to this problem is the emergence of Collateralised Debt Obligations (CDOs), and on the other hand, institutional investors like Intermediate Capital Group note they are struggling to get the allocations they want for their CDOs. In the case of the United Biscuits deal Intermediate Capital Group’s allocation was cut to less than 40 per cent of what it wanted.
After putting together two European CDOs structures, which invest approximately 45 per cent in high yield bonds, 20 per cent in mezzanine (primarily sourced from its parent), and 35 per cent in leveraged loans, Intermediate Capital Group is not immediately keen to do another. “We would rather, in certain market conditions, work another way and have more flexibility,” says Andrew Philips at Intermediate Capital Group.
For Philips, who moved across to the asset management side of Intermediate Capital Group three years ago, launching a CDO or Collaterised Bond Obligation (CBO) for European paper is a bit of a case of putting the cart before the horse in that such structures have tended to be a by product of a diversified and mature market, if you take the US example. (Intermediate Capital Group got started with a CDO following the reopening of the European high yield debt market three years ago at a time when pundits were heralding European high yield as the replacement for mezzanine finance.)
New entrants to the European CDO market do not share Philips thoughts on the difficulties of sourcing paper and replacing it when it reaches repayment. Admittedly they have yet to launch. Mid market private equity firm Duke Street Capital intends to launch a CDO, which is being structured and advised by CIBC.
It is, says Ian Hazelton at Duke Street Capital, nearer to the euro800 million than euro500 million mark the rumour mill is touting both figures.
Hazelton notes that Duke Street Capital’s CDO can take up to euro25 million per transaction, which it believes is important to get on the bank’s syndication hit list. Intermediate Capital Group seeks amounts of around euro10 million to euro15 million. Simon Hood, senior representive and managing director at ING Capital Advisors, which is soon to launch a euro350 million to euro400 million CDO structured and advised by Goldman Sachs, is looking for deal participations of around euro5 million.
Interestingly Andrew Philips at Intermediate Capital Group notes that the firm had no difficulties finding paper for its first CDO and that the banking market was particularly supportive not so surprising given that it is in the banks’ interest to foster new institutional investors. It is replacement paper and the follow on CDO that has been difficult at times. Given ING Capital and Duke
Street Capital’s presumably bullish view of the CDO market from the size at which they have chosen to launch it may be that view is tainted by the active warehousing that goes on during the structuring phase.
Simon Hood, though, makes a number of positive points. “The secondary market is clearly a lot less liquid than it is in the US. But as the credit situation of the banks worsens they will look at their portfolios, which in turn may throw up opportunities in the secondary market in coming months.” He goes on to point out: “The euro denomination has helped make the market a lot more user friendly than it was.”
But what cannot be ignored is Christopher Rist’s point that the European leveraged finance market is slightly less price sensitive than some of the other debt capital markets because it is more of a private investor market in that debt tends to be held by bankers in Europe. Andrew Philips, who notes that the CDO is a function of a mature market and who has struggled at times to find good quality paper for his CDOs, points out that in the US 60 per cent of all leveraged loans end up in the hands of institutional investors. This in turn has meant the role of banks in the US has moved away from holding paper to working for structuring and underwriting fees. This trend is in part being seen among banks operating in Europe although many both hold paper and underwrite and structure deals. When / if a wholesale shift to a US approach happens European CDOs are likely to boom because they won’t be competing with the banks for paper.
Another factor worth remembering when talking about pricing in the European leveraged finance market is that, unlike the US, there is not absolute price transparency. This imposes certain conditions on the European leveraged finance market. Namely, there is no hard and fast benchmark of recent similar credit deals that must be adhered to and this lessens the chances of the European leveraged finance market adopting a herd mentality, as is so often seen in the US. Consequently, bankers can choose to look at the fundamentals of a deal and adopt a certain level of creativity in the way a transaction is structured.
Returning to the issue of larger buyouts this has affected the structure of the debt, as well as the increase in the size of the equity component of the deal. Equity sponsors are struggling to keep the equity component of the deal within parameters that will enable them to deliver the required returns on their portfolios. So it is not surprising to hear Marc Ciancimino, associate at Pricoa Capital, note: “When you are pricing a piece of mezzanine the biggest discussion is on the warrants. It is becoming more typical for mezzanine to have a rolled up constituent to bridge the gap between mezzanine and equity warrants.”
The rolled up constituent of the package doesn’t usually get repaid until exit and as such carries an expensive coupon for debt. But it keeps the bankers happy because there is no cash coming out of the business and the equity sponsors happy because beyond its high pricing – it doesn’t impinge on the equity component.
How common the rolled up element of the PIK instrument is depends on who you speak to. Most can name two or three deals that have carried the instrument (Vantico, General Healthcare the original buyout that is.) Perhaps the best thing about the rolled up element is that it can be as attractive to the mezzanine provider as to the equity sponsor. If, from the mezzanine provider’s perspective, the equity sponsor has been overaggressive, then it is preferable to have a higher return on a roll up element rather than sitting with equity warrants.
Increasing deal size brings other concerns for debt providers as Christopher Rist of CIBC points out: “The main issue at the moment surrounds the increasing number of global businesses that are being looked at by PE sponsors. Because these businesses are global it is common to have sales into the US and those businesses are suffering from the fact that US earnings are softening. Consequently there is less enthusiasm by the PE sponsors to pay a full price and from the debt funders point of view leverage at the end of the year is probably going to be higher than the company started out with. So debt funders have to accept that things will get worse in the short term but that the upside will be there if the business successfully rides the economic cycle”.