Focus: Debt Finance – Europe getting extra leverage: Despite concerns about Y2K the buyout debt market has proved its resilienc

One could have been forgiven for thinking that the threat of Y2K chaos towards the end of last year was set to bring the European buyout market to a standstill. In fact, all it meant that was that the market’s practitioners were able to take a proper Christmas holiday for once. By the time they returned to work in the New Year, dealflow had returned to healthy levels, proven for example by Cinven’s GBP280 million ($450 million) buyout of Odeon Cinemas. They were also able to observe that the value of buyouts in the UK – Europe’s most active market – was once again a record at GBP13.5 billion last year.

For debt providers, cautious to commit large chunks of capital at a time of such uncertainty, the Y2K anti-climax came as a relief. Says Leith Robertson, managing director of leveraged finance at the Royal Bank of Scotland: “It had less impact than I thought. There were scares about banks not funding in the run-up to the New Year but we just carried on. One problem was that with technology businesses it was difficult to gauge to what extent those that were going well was due to business picked up as a result of Y2K. So there was a certain effect, but the last quarter of last year turned out to be a good one.”

Positive outlook

Looking forward, few feel that the outlook is anything other than rosy for the next 12 months at least. Craig Wilson, head of structured finance at Bank of Scotland, was not as happy as some about the level of deal activity last year, despite the bank itself having completed 63 major buyouts in the UK. “Last year, deal volume was lower than previously. But at the moment, the early signs in 2000 are that the markets in the UK and continental Europe are far stronger than at the same time last year, and we are seeing good quality businesses.”

Some leading players feel that there is now less aggressiveness in structures. “There’s been no increasing aggression in the structures,” asserts Robertson. “An interesting feature is that mezzanine has come back into the big deals at the expense of bonds – you are seeing big chunks of mezzanine that one or two years ago would have been bonds. People are beginning to see that the greater cost can be justified on the basis of greater flexibility.” RBS’s own mezzanine finance unit, RBS Mezzanine, had an active year in 1999 as it worked on buyouts such as Amtrak (GBP86 million) and Aviagen (GBP110 million) as well as arranging finance for the GBP480 million securitisation of train leases for West Coast train franchise.

Mezzanine

Certainly, there has been a rash of mezzanine fund raising recently. Of the mezzanine specialists, Mezzanine Management looks set to break new ground with an anticipated final close of $500 million for its latest fund. In addition, investment banks have weighed into the mezzanine market with the likes of DLJ, Goldman Sachs and Merrill Lynch all announcing mezzanine funds of $1 billion-plus. However, it is thought that the majority of these funds may be invested in the US, with a smaller (undisclosed) allocation being targeted at Europe.

While high yield bond issues continue to attract support, and their increasing issuance in support of LBOs in the long term does not seem to be in doubt, last year was inconclusive in terms of the readiness of European investors to embrace them. This stems from the poor performance of many high yield issues so far, with 30 to 40 per cent of issues in the sector over the last two years reported to be trading below par or at distressed levels. In 1999, only the issues in support of Kappa and Leica were unreserved trading successes.

One leading leveraged finance professional maintains: “There is not huge liquidity in the [high yield] market. For bonds to be feasible, the business has got to be large and stable – probably GBP500 million-plus, because you’ve got to have enough of an investor base to make it tradeable.” He adds: “High yield bonds are certainly not the ideal solution where you have a platform deal and you have to keep changing the structure every time you make an add-on acquisition.”

However, there is little doubt that the largest European LBOs will continue to be fought over by those banks which can at least offer a high yield capability. In Europe last year, the market was dominated by so-called one stop shop providers. This was shown by Acquisitions Monthly’s 1999 MBO league table for lead debt arrangers in the UK, where the likes of Chase Manhattan, Deutsche Bank and JP Morgan finished in the top five.

US relationships

However, while being able to provide holistic financing solutions is undoubtedly an important part of the equation, another is the depth of the relationships which the banks are able to boast with the continent’s leading financial sponsors. This helps to explain why the likes of Chase and JP Morgan as well as Goldman Sachs, Merrill Lynch, DLJ and others have been able to muscle into the European LBO market. It is no coincidence that KKR has just completed its fourth major deal in Europe over the last 12 months, having completed only one in 13 years prior to that. Hicks Muse Tate & Furst and Texas Pacific Group have also completed major deals in recent years and – given the size of their funds – it is no surprise that US private equity houses are tipped to be at the forefront of the market in years to come.

The advantage of this for US banks is clear according to Simon Clarkson Webb, managing director of leveraged finance at WestLB: “The large deals have more chance of being done by the US VC houses, and I think the European houses will have to go out and raise larger funds in order to compete. What does that mean for the bank market? It pushes the American financial sponsors more towards their normal stable where they have got their debt from historically, which has been the likes of Chase, Merrills and Bankers Trust (now part of Deutsche Bank).”

Syndication

The syndication market has demonstrated gradual recovery since the financial crises in Russia, Latin America and the Far East, as a result of which a lot of second tier’ banks pulled out. But even last year, selling debt into the market was not an easy task, and many banks were left with exposures greater than they would ideally have liked. Leith Robertson suggests that it strange that, at a time when the value of private equity investment is higher than ever before, debt liquidity seems to have declined. He points to a number of possible reasons: “Margins in corporate lending are better than they used to be, so why bother with leveraged loans, where the risk is higher?; bank mergers, as just because two banks come together doesn’t necessarily mean they will do twice the number of deals; and perhaps the level of risk is being under-priced.” Elaborating on the third point, he points out that in the US, pricing is around 50 to 75 basis points higher at present than in the UK.

The gap created by a lack of bank liquidity may be about to be filled by non-bank institutions, given the establishment last year of a leveraged loan group by PPM – the global asset manager for the UK’s Prudential Corporation – and Intermediate Capital Group’s launch of a euros 356.5 million CDO issue investing inter alia in European senior secured loans. Some observers feel that European private equity should provide a natural home for certain types of income-related insurance products.

However, no-one should be getting carried away by the potential for greater liquidity from this source just yet. “There’s been a lot of talk about it, but the number of institutions in the European market is still very small – it’s certainly not something that will take off overnight,” insists Greg Lomas of CIBC World Markets.

However, in the highly developed US market for non-bank investment in leveraged loans, there were just 14 institutions participating in 1993 but, at the last count, there around 150. As with the securitisation and high yield markets before it, the growth of the European institutional loan market will be dictated by investor education.

Providing the syndication gap’ can be filled, the European buyout debt market looks to be in a reasonably healthy state for the forseeable future. While there is always the possibility that another global financial crisis could be lurking just around the corner, the generally benign economic climate in the majority of European countries should create the possibility of yet another record year.