Rampaging corporates

The fall of the leveraged loan market is of course the topic of the moment. The list of large underwritten deals that cannot be syndicated is growing by the day. Whether this is a mere “blip”, a sensible market correction or a real drying up of liquidity is not yet known.

But no matter what the future holds for the leveraged market there is no doubt that some of the froth has been knocked off, and this could well spell an easier time for corporates that have for a long time been unable to beat the sponsors on price.

Unstoppable force

Until the news came through last week that banks syndicating £5bn of senior loans on KKR’s leveraged buyout of Alliance Boots had failed to sell, debt liquidity had seemed unending, the flood of credit unstoppable. The underwritten public-to-private deal must still go ahead, but the debt will now stay on the banks’ balance sheets – although they have managed to get the junior debt away at a loss-making discount (see financial markets p10).

Banks that have underwritten debt that remains unsold must now conduct a co-ordinated sell-down, with stabilisation agreements to hold up prices.

As a result, as many as half a dozen global banks are expected to cease writing any major new leveraged finance business as they deal with unsold debt. It is possible that only once these large deals have worked through – a process likely to take several months – will the leveraged finance market come back to life.

There had been signs over the last few months that the world’s main source of liquidity was drying up. CLO funds, which over the past four years have come from nowhere to overtake banks and supply around 60% of market liquidity for loans, have taken fright at delinquency in the US sub-prime mortgage market.

CLO fund managers, which had been raising new money every week, can no longer find enough willing investors at the prices asked. The cost of raising CLO funds is more than can be raised from investors, who can find better rewards in the secondary market – where prices have come off to such an extent that senior debt such as ProSieben Opco – an extreme example – is trading at 93% of par (see financial markets p.12).

And it will get worse before it gets better. At the end of July, CLO investors will have marked their investments to market, and may be shocked to see the drop in value.

But it’s not a total disaster – say bankers. It is just a drying up of liquidity – a technical matter. The fundamentals are still there: there have been no defaults, and coupons are being paid. This will gradually restore cash, which must be reinvested. So as the unsold leveraged finance deals drip through into the market, cash flows in and secondary prices float back up, liquidity will return, they say.

In the meantime, however, what does all this mean for the corporate buyer? Alongside the tightening in the loan market, club deals are being frowned upon by regulators on both sides of the Atlantic and the political uproar over the takeover of major blue chip companies threatens to tighten costs still further through increased taxes on private equity deals.

In this environment, Imperial’s offer to finance its Altadis acquisition through a £5bn rights issue and Delta Two’s ability to purchase a stake in Sainsbury using the petro-cash pouring out of its coffers look very attractive. They give such acquirers a huge advantage.

Delta Two could not be called a conventional corporate acquirer but neither is it a pure private equity investor. Its outlined 600p a share bid, worth £12bn, represents a significant investment in growing the business: £3.5bn over the next five years.

In both instances CVC has been beaten on price. With the debt markets beginning to shake and private equity investors struggling to raise enough money to fund their ambitious deals, listed corporates, which are less reliant on debt for acquisitions, are not experiencing the same “drag” on their ability to do deals.

Another good example of corporate strength in this market is mega-miner Rio Tinto, which calmly managed to raise US$38bn to finance its cash offer for aluminium producer Alcan. Its paper looks likely to be lapped up given the continuing surge in metal prices.

“Strategics will come into their own after the top of the market, though companies will need strong boards to take full advantage of M&A opportunities in more challenging market conditions,” says Peter Baldwin, a lawyer at Cadwalader Wickersham & Taft.

Meanwhile, listed companies are also fighting to compete better with private equity by toning down regulation and improving executive remuneration packages.

In addition, Baldwin expects that smart money will now head away from private equity and into more alternative investments, with groups such as Cerberus and Apollo set to benefit.

Stronger mid-markets

The accepted wisdom is that larger private equity players will be hit harder than mid-market groups, since these tend to have lower debt levels. Moreover, private equity-backed buy-and-build platforms will still be able to act on synergies.

Hugh Brown, a partner at PricewaterhouseCoopers, argues that mid-market multiples are still too high effectively to entice corporates back into the game.

“Multiples are 7x knocking on 8x, “ Brown says. “They have to come down a long way before there are going to be significantly more corporates in the picture. I think there will continue to be the normal level of corporates – there will not be a switch from secondaries and leveraged buyouts, you have to have a little bit of memory. Even six months ago we would not have predicted mid-market multiples would be as high as 7x–8x.”

But that said, the mid-market buyout firms are not off the hook. According to new research by Close Brothers, more than two-thirds (68%) of CEOs and CFOs of FTSE 350 companies expect to be involved in a merger or acquisition over the next 12 months, perhaps giving the mid-market buyout firms a run for their money.

“The bullish rhetoric from FTSE 350 companies reflects the level of M&A these companies have initiated over the last year,” says the Close Brothers report. “In the 12 months to the end of June 2007, FTSE 350 companies were responsible for 430 M&A deals, valued at over £75bn.”

Close Brothers believes that with the debt markets becoming less buoyant and banks becoming more selective about which situations they will lend to, private equity firms will not be able to get as high a degree of leverage as they have been used to and will therefore be less competitive in auction processes.

Richard Grainger, CEO of Close Brothers, says: “This is good news for public companies. With many auction processes being highly competitive and leading to significant premiums being paid for assets, the fact that private equity groups may now find it more difficult to leverage up to the levels they recently have been, might be the break that public companies need and give them the opportunity to make strategically enhancing acquisitions at prices that don’t jeopardise the rationale behind the deal. Synergy will once again outbid leverage.”

The research shows that of those FTSE 350 companies eager to do a deal in the next 12 months, 53% will be looking for domestic opportunities, with 30% also looking to EU countries and 38% looking to the US.

In spite of their apparent eagerness to make acquisitions, when asked what might hinder them from doing so, 64% of respondents cited high valuations; 38% stated macroeconomic conditions; 27% said that competition from private equity houses was slowing their intentions; and 20% spoke of rising interest rates hindering their ambitions for growth.

“Twelve months ago companies were saying valuations were looking high but they have continued upward,” says Grainger. “Rising interest rates are obviously a concern for over-leveraged companies but corporates have to look at the positives.

“Buying strategically enhancing assets that generate significant synergies is something that their private equity counterparts are often pushed to achieve. So while there will always be excuses not to execute M&A deals, there are many advantages to doing so, even at this stage of the cycle.”

Brown at PwC also urges a note of caution to mid-market private equity firms, arguing that deals in the £200m–£300m range will also be hit by the tightening lending environment.

“Quite a lot of loans can’t be syndicated in the mid-markets,” Brown says. “There are a lot of mid-market consumer deals where high multiples have been paid and they can’t syndicate them; banks don’t want to do more than £80m on their own – £200m–£300m deals will be hard to syndicate down.”

However, he says: “We are still getting term sheets from banks offering money, they are still open for business and keeping work flows going. They are playing safe and seeing if this is a blip in the market before taking decisive action.

“The staple financing attached to some exits sale mandates are still in place; we have conferred with the banks and they are sticking with them,” Brown says. “We have also had a new staple finance put in place in the last few days.”

He adds: “I personally think it is merely a price correction; I doubt it is anything more serious. Prices and valuations will go down because they are at an all time high – but they still have a long way to come down before they are too low.

“Vendor expectation is still optimistic; there still bit of froth in the market. If you didn’t read the papers, you wouldn’t predict what is happening apart from loans not being syndicated – it just feels like the normal rough and tumble of business,” Brown says..