European staff of the rating agencies have long had their eye on the local leveraged finance market, all too aware that their US colleagues are making a healthy business out of rating the debt that emerges from this quarter Stateside.
Europe’s private equity buyout investors have staunchly resisted this move to an American modus operandi, partly out of desire to control transaction costs but mainly to protect the privacy, and thereby the strategic interests, of the businesses in which they invest. And for now the market has worked in their favour, with leveraged loan underwritings and syndications ticking along without the aid of a rating. But with the buyers of Europe’s leveraged debt paper changing, can they continue to resist and if they can’t what will this level of transparency mean for Europe’s leveraged buyout market? And are public debt ratings that relate to the companies underlying institutional investors private equity interests of use to these institutional investors? Lisa Bushrod reports.
Buyers of Europe’s leveraged debt paper are changing.
“Things are moving really quite rapidly towards a rather different market than existed before, one that is more diverse than it was in terms of the number and type of lending institutions involved,” says Stewart Binnie, a partner at Augusta Finance.
Binnie points to just 3% of European leveraged debt being bought by non-bank institutions in 2000 (see bar chart sourced to Augusta Finance). This figure increases to 11% the following year and is estimated at 17% for 2002, although Standard & Poor’s date for 2002 puts the institutional investor figure slightly higher at 19.4% (see pie charts.) Interestingly, this shift is down to banks playing a gradually smaller role in the primary market.
In explaining what has bought about this change a number of factors rise to the fore. One being that this is a sign that the European leveraged debt market has reached a certain level of maturity and as such this is a natural evolution. The sustained beginning of a secondary trading market in this paper reinforces this claim. Another explanation is that the poor performance experienced by institutional investors in the public equity markets has forced a rethink. With a finite supply of investment grade paper, plus the need to present an enhanced return on their capital, a move into sub-investment grade leveraged
debt is the natural next port of call.
The most pressing case for explaining the shift in non-bank investors in leveraged debt is the changes that loom in Basle II. As is illustrated in the table titled ‘Capital risk weighting under Basle II’, leveraged debt, which by its nature is sub investment grade, now requires a capital risk weighting of 100% or more. It is also worth looking at the table titled ‘Five and ten year cumulative average default rates 1981 to 2002’ at this point since a comparison between this and the earlier table shows that for corporates, around which the leveraged debt market is built, there is not a satisfactory recognition of actual risk under Basle II.
The trend for banks to refocus their business away from business lines that incur heavy capital adequacy penalties looks established. Given this fact and that many of the new institutional investors may be unfamiliar with the leveraged debt market, does this mean leveraged buyout houses will come under renewed pressure to put their deals through the rating process?
Possibly, but it is not a development that they will welcome as Dominic Crawley, European head of leverage finance, structured debt and high yield bond ratings at Standard & Poor’s, atests. He says: “Bankers have told me that private equity sponsors use the requests from banks that the debt should be rated as a negotiating tool arguing that their proposals will not be considered if the rating remains as a financing requirement.”
LBO sponsors have been a lifeline for many investment banking loan operations during the last two years. This is because the general corporate malaise has stumped the normal flow of deals in the non-buyout related corporate world. A less certain economic future and the withdrawal of banks from the market with problem loan portfolios and realignment issues has meant some deals are less easy to complete on than others. Such situations might be eased by the attachment of a rating to a chunk of debt. But, says Crawley: “Banks will never admit that they have paid for ratings. It would be a sign of weakness, a loss of virility. But the fact is they do when syndication requires a rating and the private equity house refuses to pay.”
However, at times ratings can be as damaging to a deal as LBO sponsors perceive them to be. “There are only two situations where I can imagine that a rating would not be helpful. The first is where the mandated lead arrangers are selling a deal on the expectation that it is, say, a BB+ and the rating comes out at, say, BB-. And second, some banks can underwrite and buy un-rated pieces of debt, but might be stopped from doing so if the debt is rated and that rating is below investment grade, i.e. below BBB-. I understand that this is the case at the moment for many Spanish and Italian banks,” says Crawley.
The latter reason prevented the rating agencies from benefiting from Europe’s largest ever buyout of the Italian Yellow Pages. Rating agencies would like to see all deals over €500m rated and with this deal some ten times that value there was some disappointment, especially given the view that if the rating discipline can be applied to the larger deals to facilitate their syndication (as has happened privately in the past) then the pressure would gradually be felt by deals lower down the food chain. Only as far as €500m, however, since below this point enters the realm of the club deal where the case for a rating is a hard one for anyone to have to make.
Credit views are already forming in the market thanks to an increasing number of private ratings that the agencies are being asked to do on LBO sponsored leveraged paper. Crawley says: “For example, we have carried out over 30 credit estimates for institutional investors across five deals invested in by one private equity house alone. [LBO sponsors] may not like ratings, but they should understand that the market (and the rating agencies) develop a credit view on their investments without any direct input from the equity sponsors themselves.”
Given that credit views are out there, there comes a point when the LBO sponsors need to decide whether to continue sitting on the fence or get off and join in the debate with the hope of influencing it. But the LBO sponsors might still resist because they don’t want the strategic vision or their angle on the company or industry out there for public consumption. Obviously such information could affect the way competitors operate thereby undermining or eroding the investment’s raison d’etre. But given that US LBO sponsors have long managed to operate within the disciplines of public ratings this might
be an excuse rather than fact.
For the time being banks still make up the majority of leveraged finance debt investors in Europe and most of the deals seeking leveraged finance are unlikely to achieve an investment grade rating. These two factors make the prospect of a sub investment grade rating distinctly unappealing, when bearing in mind the capital risk weightings required by Basle II.
Robin Menzel, a partner at Augusta Finance, says: “Most companies below $750m sales in Europe have a very hard time to get to an investment grade rating so as a sub investment grade risk they will find themselves faced with leveraged finance pricing, which starts at 150bps over Libor. Moreover, the European lending market is increasingly differentiating between credit quality and the traditional bank supply of loans to the mid market is weak. Consequently, the days of banks lending to mid market companies at Libor +50, irrespective of credit risk, are probably over for good.”
But with banks moving out of the market and that trend set to continue if Basle II goes ahead in its currently propose form, other institutional investors may prefer to invest with the security of a rating. How quickly these new entrants will bring their preferences to bear on the market remains to be seen. However, it is interesting to note that it took just three years for the US leveraged debt investor market to move from a 50% participation by institutional investors to around 80% last year.
But if LBO sponsors are going to be forced down this unwelcome road they should insist on it being a give-and-take situation, whereby they give into the rating scenario in return
for a negligible underwriting fee on the deal. Given the relatively straightforward nature of selling rated paper this seems an equitable trade-off, although with the current value of underwriting fees it’s likely that the banks will resist such a development as ferociously as the LBO houses have resisted ratings to date.
But if ratings do become part and parcel of the LBO sponsors transaction process will they have any material interest to those institutions that are ultimately investing in the equity on the deals through their private equity portfolios?
The effect will probably be limited effect if only because the €500m plus end of the deal market is relatively small. Between 1999, 2000 and 2001 there were over 25 deals of this size each year, last year the figure was over 35 deals and so far in 2003 some 17 deals have been recorded, according to Thomson Securities Data.
Rating visibility has been present for some of the largest deal that have launched European high yield offerings as part of their debt structure in recent years. Here ratings have probably only served as early warning signs for investors rather than as a significant aid to transparency. There is little reason to suppose that paper ratings will do anything different.