Heading for a winter workout?.

In fact the only thing to have really changed in the restructurings and workouts ‘will-it-won’t-it and when?’ debate, is that the weight of evidence has increased during 2005. Much of this evidence relates to the highly liquid nature of Europe’s debt markets over the last couple of years, which last year funded a plethora of recapitalisations and secondary buyouts as well as new deals, many of which were done on leverage and contractual terms that buyers of debt could only dream of previously. And in that regard, 2005 has delivered more of the same, albeit a little magnified.

“There is an oversupply of debt. Not only is it getting cheaper for borrowers, but there are better contractual terms [for buyers.] We have seen a trend of increased levels of borrowings and we are seeing much more complex facilities going in place with greater syndication to overseas banks. This could amount to an increased probability of covenant breaches; the more leveraged you are, the more chance you are going to trip up over banking terms,” says Andrew Merrett, director of corporate restructuring at Close Brothers Corporate Finance.

Rating agency Standard & Poor’s (S&P) has been analysing the deals that have happened in the first half of 2005 against recent previous years to see how far, if at all, the market has moved in real terms. “The underlying credit risk of new transactions has clearly deteriorated. The reasons are two-fold. First, we have seen increasing leverage, which implies additional financial risk. Secondly, we are seeing a deterioration in business risk as well and are seeing transactions being done in sectors that lend themselves less comfortably to being LBOs because they are in businesses with great cyclicality and great capital expenditure requirements,” says Dominic Crawley of S&P.

Audrey Whitfill, who is a director of European leveraged finance at S&P’s and responsible for covering recovery situations, adds: “Average quity contributions were at their lowest levels during H105 at 31%, whereas during 2004 average equity contribution was 35%. Based on our private credit ratings, the deterioration in credit quality has seen the average rating go from BB+ in 2004 to B today (at the end of H105). That’s a 3% to 10% jump [in the rate of default] over a year time horizon.” Of course, over longer time horizons the default rates rise exponentially.

Despite the weight of anecdotal and empirical evidence, it seems to be anyone’s guess as to when restructurings and workouts will start to surface. There also seems to be some debate as to whether those defaults will be corporate or sector specific; in other words, individual companies that were simply over-leveraged against ambitious business plans or companies within sectors that face specific challenges.

Speirs says: “The issue with highly leveraged private equity deals is they can have problems with capital structures even when the business is not performing badly but just performing less well than projections on the basis of which the structure was put together.”

In the case of sector specific troubles, which is arguably less concerning, so long as you’re not exposed to that particular sector, retail is seen as the only obvious candidate, given that consumer confidence has crashed this summer in the UK has been in the doldrums for a couple of years across much of continental Europe. In 2004, £2.449bn was spent on retail focused companies by European buyout firms, in the first half deals totalled just £254.6m. While 2004 figures include some mega deals (New Look £700m, DFS £507m), inclusion of similar deals in the first half of this year wasn’t for lack of trying. Just some to fall through the gaps were Somerfield (£1.1bn), Woolworths (837m) and Boots (£1.3bn.)

The last time a sector took the brunt of restructurings and workout professionals’ time was in 2000/01 when the power and telecoms sectors had engaged in mass infrastructure expenditure that couldn’t be paid back as prices plummeted and the majority of customers were fixed into low priced contracts.

So far the most discernible activity in the restructurings and workouts sphere has been concentrated among the investment banking, accountancy and independent corporate finance firms that have bit-by-bit been adding to their expertise in these areas. Even this is difficult to pin down precisely with talk of hires generally being explained as filling existing vacancies.

New faces

But what’s changed this time around, compared to the last cluster of restructurings and work outs, is the people doing the lending. In the last three years a healthy secondary debt market has emerged in Europe, something that has long been a feature of the US capital markets. Merrett says: “2002 to 2003 was the start of a whole new wave of money coming into Europe, primarily from the US, where the secondary market is more established. There are now in the city [of London] very sophisticated debt trading operations, debt broking desks, in number of investment banks that specialise in sourcing debt around the world, especially Europe, and trading that out amongst people buying that debt in London. That has an effect on how workouts and restructurings get done, because the constituents have changed.”

This has led to quite some nervousness among private equity players, with at least one ‘blue chip’ LBO firm understood to be attempting to prevent the debt paper of its investee companies being sold to hedge funds, who make up just one element of the new players into Europe’s primary and secondary debt trading. It’s hard to know whether this is just absurd naivety or out-and-out arrogance on the part of the firm in question that it should attempt to control publicly issued paper in this way. And perhaps more amusing as a result that investment banks under such pressure are rumoured to have constructed vehicles to front for hedge funds, thereby hiding from the issuer who is actually buying their paper.

It’s not all cloak and dagger, though, with some LBO firms reportedly holding road shows for hedge funds, having woken up to the new reality, in much the same way as the majority of FTSE100 companies have done. Even if their motivation is simply know-thy-enemy, it’s not a bad strategy. One thing about the hedge fund industry is that it can be even more opaque than the private equity one (few even have company websites, given the regulation regarding soliciting funds and that the fund raising process for hedge funds can be almost continuous), so it’s hard to determine a fund’s strategy or goals in moving into a given situation.

Whitfill sums up some of the concerns: “It’s an historic fact that banks have worked through [restructuring situations.] But we have seen a couple in trouble already where hedge funds holding senior or subordinated debt have influenced the restructuring. It the past, it has been in the collective interest of the banks to work through these situations. Hedge funds are in this for short-term return investment (and may have purchased at less than par). They are playing the market more aggressively than banks are used to. So, it’s difficult to predict which way the market will move in the future.”

But as Speirs notes, the private equity firms themselves can be as much of a thorn in the side of restructuring and workout situations. “Many private equity funds have people who have experience of distress, so they can help the management team. If there is a significant diminution of the private equity firm’s equity this can change the dynamics sometimes, and we see some playing for time in the hope of getting their equity value back up,” he says.

But it’s not as simple as playing good cop to someone else’s bad cop, as Close Brothers Corporate Finance’s Merrett points out. “In our opinion [the secondary debt market] is a good thing. It gives institutions another option to sell in the secondary market, and there is a reduced rate of corporate failure because there is a different dynamic around the [restructurings/ work out] table. The people involved are most interested in creating a deal and perhaps that is because they bought the debt in the secondary market,” he says.

Although private equity firms may feel perturbed at the thought of which entities may have invested in their investee companies’ equity and their motivations for doing so, they may still expect to see their arranging bankers party to any future negotiations. But anecdotal evidence, at least, suggests this too might be overly optimistic. Even some of the core leveraged finance arrangers are understood to be taking a strategic, rather than relationship driven, view on the market. Crawley says: “Some [banks] in the market are making a positive decision to scale back their work out groups and reinvest in skills around trading and risk hedging through the derivatives market.”

Merrett concurs: “Syndicate banks don’t always want to put in the time and effort that going into a work out requires and instead are putting paper in the secondary market.” It’s not just time and effort but Basle II requirements that are affecting these moves too, which suggests that even private equity firms in the lower end of the buyouts mid-market should sit up and take notice of these developments. S&P notes that the concern is such among banks that it has been privy to the work of a consortium of five leading European leveraged finance banks that have agreed to pool their data on defaults to be published on an aggregated basis.

With one group’s potential misfortune comes another group’s potential opportunity, this time it’s US investment banks that are reported to be offering credit default swaps (sometimes called total return swaps) in the market. Ian Hazelton of CLO fund manager Babson Capital Europe dismisses these for his business, on the basis of expense and giving up liquidity. These credit default swap agreements allow, at a price, the holder of paper to sell out at a given price. But given the fact that the holder can no longer sell the paper once it’s subject to such an agreement and that the upside is capped, this may limit their take up.

But the worry about how the new breed of European debt investors will behave may prove to be a false one. “It’s fairly unusual for transactions in serious trouble to suffer formal payment default. By and large, certainly over recent history, transactions that get into serious difficulty go through a private restructuring process. We will see if that pattern of behaviour continues over the next six months,” says Crawley.

Hazelton is optimistic that, for the most part things, won’t end up in turmoil, perhaps only because the alternative could be far nastier! “Because we don’t have Chapter II [in Europe], it’s in everybody’s interest to avoid the uncertainty of courts getting their hands on the work out process,” he says.

And these deals take time, even where there is a clear will to resolve issues. Speirs notes the timeline of his involvement in the EMTV restructuring: “With EMTV we were appointed in May 2003, we cut an economic deal and got heads [of terms] sorted by December 2003 and completed in May 2004, which is not an untypical timeframe,” he says.

But it’s unlikely that everyone will get through the winter unscathed, given the slipping of contractual terms and big jumps in what has been seen as acceptable leverage in the last year or more. Hazelton says: “We have seen covenant controls chipped away at. However, there appears to be a sea change in the market, and I think we have reached the high watermark in debt multiples. We have already seen instances of lenders committing only after changes in controls and leverage. It’s important to remember that senior loan multiples have not increased that much and the real progression has been in the style and amounts of subordinated tranches, including PIK, which acts pretty much like equity.”

And in the end, more private equity investors, across the spectrum of deal sizes, might encounter problems than they would expect. While the behaviour of this new breed of debt paper investors (including pension funds, life assurance, CLOs, CDOs, not to mention hedge funds) can’t be reliably foretold in cases of workouts and restructurings (at the distress level of less than 85 pence in £1), when the paper of investee companies falls into the areas of stress (95 to 99 pence in the £1) or impaired (less than 90p in the £1), their behaviour is equally unknown, which is simply a function of a fledgling secondary market about to embark on the first test of its strength.