Concerns about rising debt levels in transactions has been reinforced by a survey of mid-market M&A, which found that 70% of respondents believed current and recent deals were over-leveraged. So, are current debt levels in the mid-market unsustainable and is there a risk of wider collapses for the private equity industry?
Levels of debt in European mid-market private equity transactions are dangerously high, according to a poll by KPMG in June. The survey found 70% of mid-market respondents felt recent and existing transactions were “highly over-leveraged.”
Apax founder Sir Ronald Cohen and Alchemy managing partner Jon Moulton have recently flagged up the risks of current debt levels in the market. Moulton has warned of a “big, black cloud hanging over the industry” and Alchemy has decided to raise a special situations fund to invest in distressed debt because of its belief that there is a growing risk of companies defaulting on debts. Cohen has described a “dangerous combination” of rising debt service levels and falling sales and profits.
There is no doubt debt levels in transactions have increased. According to ratings agency Standard & Poor’s (S&P), average debt-EBITDA multiples for European LBOs increased from just over four times in 2003 to nearly six in Q1 2006. Some companies, however, are thought to be borrowing at significantly higher multiples and there are particular concerns about the robustness of sectors such as retail in the face of growing economic pressures.
“Credit has been increasing in the last two years, although it’s hard to say whether at current levels it’s too high and at what level the market could turn,” says Paul Watters, head of loan and high-yield ratings at S&P.
He says he is concerned at the increased leverage, as well as the high levels of dividend recaps, which in Q1 2006 represented 20% of the European market. “There’s also been an increase in secondary and tertiary deals, which were 45% of the market, and their preponderance is usually an illustration of a bull market,” says Watters. The reason for all this is that sponsors are having to pay more to acquire companies, says Watters, and thus acquisition multiples are very strong.
Mick McDonagh, a private equity partner at KPMG, says he is not surprised at the current concerns over debt levels in the mid-market given the increases in the last year or two. But he adds: “A lot of people have been calling the top of the market for the last six to nine months but people are still taking on leverage and it feels sustainable.”
In larger deals people are sometimes turning down current leverage levels because the debt instruments often used in those deals are quasi equity. But the mid-market tends to rely on fairly traditional instruments that people recognise, says McDonagh.
He adds: “People are taking on the leverage because they can do their modelling and calculations and work out if it’s going to work for them. “Many intuitively feel the increase in leverage must be bad news but there is still pretty high confidence in the mid-market as people believe businesses are well structured and well placed and that there is a generally benign economic environment.”
According to James Stewart, a partner at mid-market house ECI, increased valuations for businesses are being driven by a number of factors, particularly trade acquirers having liquidity and an over-capacity of funding in the private equity market. He acknowledges prices and debt levels are high but not to the extent that a systemic failure in the markets is likely. “The senior banks, in particular, have been providing liquidity to fund transactions but they are becoming more selective with the type of opportunity they are willing to back,” says Stewart.
Stewart has observed a retrenchment by senior lenders, in that they are restricting their activity to businesses with good quality earnings and a degree of asset cover. “To a certain extent we’re seeing a flight to quality and that will reduce the possibility of a sudden downward spiral in valuations,” says Stewart, who believes pricing and valuations will not rise much above current levels and could fall to 2000 to 2004 levels.
Mark Owen, a director at private equity house NBGI, agrees that banks seem to be aware of the dangers. “It looks like they’re being a bit more sensible in this cycle and perhaps they’ve learned from the heady days of 1999/2000,” he says.
Nevertheless, in sectors such as technology, media and telecommunications Owen thinks there is risk of businesses failing as a result of high debt. This is particularly so because lending is less commonly secured by assets in non-traditional industries, he says. NBGI is more active in traditional economic sectors, but even in those sectors market valuations are being driven higher by increased debt levels. “We’ve tried to resist the trend, as we believe in sensible levels of debt and in the last three to six months we’ve dropped out of or been dropped from several transactions because we haven’t been willing to put in higher debt,” says Owen.
So far the levels of leverage in mid-market deals appears to be serviceable. But problems could arise if there is a significant change in economic conditions that affects companies’ trading, higher interest rates or some significant business failures or hedge funds collapse.
Owen says: “The main risk, especially for some of the racier sectors like TMT, is that their market drops away, as consumers reduce spending, and they find it harder to service their debt from earnings and cash flow.” He has no doubt there will be some fall-out, although the full extent remains to be seen and will depend on wider economic trends.
Much of the debt being raised is being used to refinance companies in trouble, believes Andy Meehan, vice-chairman of Gordon Brothers International, which focuses on turnaround and restructuring as well as private equity and commercial valuations. “You can argue that the leverage is being used in a positive way, to prolong the life of a business, or that it is simply papering over the cracks,” says Meehan.
He adds: “If a business trading at certain levels needs to refinance and can borrow at six to eight times EBITDA compared with four to five times in the past, then that looks very attractive in terms of cash generation. But the point is that all this money still has to be paid back and sectors such as retail are facing particular trading pressures so you’re adding an extra burden on business at a time when a small percentage drop in sales can have a major impact.”
Despite the pessimism in some quarters, KPMG’s McDonagh argues even if there were to be a high profile collapse of a portfolio company, that would not necessarily signal a wider fall-out. “There’s always the risk that something pretty high quality could crash spectacularly, but I’m not sure the market would react in the same way as 10 or 15 years ago,” he says, noting that banks are much more used to working through such problems rather than throwing their hands in the air and calling in the receivers.
Like ECI’s Stewart, McDonagh believes the flight to quality among the banks will limit the downside of future problems: “There is still a real lack of good quality assets in the mid-market, as there are still a lot of people who want to buy and possibly fewer who want to sell. That means pricing for good businesses will continue to be strong, both from private equity and corporates, for businesses that meet certain quality thresholds.”
S&P’s Paul Watters, while expressing some concerns about high leverage, is generally sanguine about the wider implications: “Given the outlook for the economy and interest rates, we’re not expecting any great pick-up in defaults over the next year to 18 months.”
Senior lenders in the mid-market are managing their exposure carefully, with covenants giving banks a significant degree of control, says Watters. Similarly, equity sponsors have been aggressive in managing their exposure by taking dividends out when they can.
“The interesting question is how the subordinated lenders are going to behave if companies start getting into difficulties,” says Watters. He adds that it has been remarkable how well the European leveraged loan market has held up, given the increasing volatility in equity markets, commodities and emerging market currencies. “There’s still a lot of liquidity in the leveraged loan market and interest in being exposed to those assets,” he says.