More debt and more distress.

The topic of debt multiples is one you can’t seem to escape at the moment. Go to any conference and there’s sure to be at least one session dedicated to the subject, and the issue will be raised in numerous others. The concern among many, and voiced at February’s Super Return conference by Alchemy chief Jon Moulton, is that the current levels of debt multiples are creating the next generation of distressed companies. But there is another argument that says these fears are exaggerated, based on a memory of the heady leverage days in the 1980s.

For their part, the people at Fitch, the rating agency, are pretty confident things cannot carry on like this for much longer. In a special report, a review of the European leverage market in 2004 entitled European High Yield Defaults Down 90% in 2004, the ratings agency called the low default rates of last year “remarkable”, but questioned whether it was sustainable: “In Fitch’s view, the European high yield default rate has most likely reached the nadir and although the default rate is expected to remain low in 2005, it is likely to trend upwards in the next two to three years. The agency is concerned by the more aggressive leverage levels observed in European LBOs.”

Fitch expanded on this theme in another report, published in February this year, called Is this sustainable in 2005? Last year the average total leverage ratio for Fitch rated LBOs exceeded 5.0x, the first time this had occurred since 2000. “Assets were rapidly recycled from their first incarnation into a recapitalisation or secondary buyout transaction with much higher leverage ratios second time round,” the report said. As an example, the secondary buyout of Picard Surgeles, sold by Candover and bought by BC Partners in a €1.3bn deal in October, saw the debt/EBITDA ratio rise from 5.9x in the original February 2001 purchase, to 7.3x.

Fitch believes the trend of high and increasing debt multiples will continue this year. The first quarter has been especially busy, with Amadeus and Rexel, and the possibility of other mega-deals such as Wind and Auna. Deals like these, which are expected to be popular with investors and will no doubt be oversubscribed, are expected to keep the debt market at its current levels.

Beneficiaries

Factors that could see an end to the high multiples range from the macro to micro-economic, from rising interest rates to a high-profile deal defaulting. At the moment, economic conditions are good, and banks are happy to leverage deals at a high debt/EBITDA ratio. It’s difficult to predict which companies will suffer when the economic climate goes sour, but the general trend in the past has been those that operate in cyclical sectors, such as retail and tourism, and those companies exposed to commodity prices, especially a sector like the automotive industry and its reliance on oil prices, to be hit first.

There are, of course, some people who stand to benefit from more distressed companies. Mark Mifsud, a partner in corporate finance at SJ Berwin, says: “One person’s downturn is another person’s fortune.” In particular, the secondaries market is keeping a keen eye on the current levels of debt being dished out. Tim Jones, a partner at Coller Capital, says: “At the moment people are doing deals at pretty racy pricing and this could turn into deal flow for us if things go wrong.”

Marleen Groen, founder and CEO at Greenpark Capital, agrees: “Deal flow will increase when a few companies go wrong. If the economy or a few companies in a portfolio take a downturn then the funds won’t be quite so liked by their investors and those LPs will be more inclined to sell their positions. The debt market will shut if a number of companies begin to default, and this means the larger funds in particular might find it difficult to get the exits at the prices they need to show the expected return to the LPs.”

Coller’s Jones doesn’t think the secondaries market will really be able to take advantage of an increase in the number of distressed companies until a few years down the line. He says: “The companies we buy now are companies that were originally bought four or five years, at the back end of the late 1990s. A lot of these also had high multiples but were driven down by their GPs, so what’s happening today is our flow four or five years down the line. A 10x EBITDA now will become 5x EBITDA because the GP will have driven the ratio down, and that’s when we buy it.”

Mega deals

It’s unlikely that secondary funds and turnaround specialists will be looking to the very highly leveraged companies for their future deal flow. A lot of the bankers in defending the debt levels argue that high multiples are only being given to those companies with strong cash flow and low spending, i.e., companies that should be able to cope in the event of an economic downturn. “Larger deals have an inordinate amount of due diligence undertaken,” says Paul Watters, head of loan and high yield ratings at Standard & Poor’s, “and their high profile ensures that all stakeholders do everything they can to ensure that the business performs up to expectations.”

It’s those companies with high capex and lower earnings that are catching the eye as a lot of them are being leveraged with 5x or 6x multiples, where even a year ago they wouldn’t have been more than 3x or 4x. Daragh Murphy, associate director of leveraged finance at Fitch, says: “The big headline grabbing deals are more likely to survive due to the stability of their cash flows, but because these companies have been given generous amounts of leverage you have seen other companies take advantage of the situation and these are the ones that are more likely to find themselves in trouble if there is an economic downturn.”

“But this always happens in a downturn, there’s nothing new about distressed companies,” argues Jonathan Russell, head of buyouts at 3i. “Yes, there will be more distressed debt out there and does having a team dedicated to distressed debt make sense, yes it does, but I don’t think there will be a huge mother-load of problems. If you have got a quality business with solid cash flows then the financing structure will be fine.”

Waiting for the drop

Investment banks obviously agree with Russell’s comments about building up a distressed debt team. The American banks spent last year building up debt recovery teams, and word has it that the London-based banks are following suit. Defaults may be rare at the moment, but this doesn’t mean they aren’t there. In mid-April Reuters reported that Gate Gourmet, the Swiss-headquartered in-flight meal provider, broke its debt covenants in December, and freeze in filing bankruptcy proceedings expired on April 11. Texas Pacific bought the business in 2002, and involved a $331.9m dual continent syndication.

While a deal such as Gate Gourmet is probably not going to send shockwaves around the debt market, it will make people sit up and take notice. Gate Gourmet may not have been one of the biggest deals around or especially high profile, but it is a company that, on paper, looked solid. It’s the world’s second largest airline catering firm, employs 22,000, and had sales in 2004 of $2.01bn.

One consequence of the debt market closing up is the challenge it will pose to funds looking to sell. At the moment the exits routes are in a fairly healthy state. Trade buyers are becoming increasingly busy, recaps are especially common in these days of freely available debt, and secondary buyouts are a regular occurrence. But what happens when the exit opportunities dry up, especially secondaries, which are so common at the moment? “Perhaps the right question to ask is how many of these businesses that are not generating any meaningful cash flow will be able to refinance their bullet loans if the there is no earlier exit opportunity,” says Watters.