Strike it lucky

The mental image of investors, lenders, asset managers and GPs crowded together on a high branch trying to get a clear view of what is on the debt market horizon is a strikingly apt one.

“Everyone’s up in trees trying to see what will happen in the next six months and beyond,” observes David Silver, managing director of the European investment banking team at Baird, the ambitious mid-market bank.

The world’s big commercial and investment banks have lost their appetite for mega LBOs as they ponder a mountain of unsold debt on their books. There is a liquidity crunch in senior debt and second lien is dead by all accounts.

The nature of markets is monkey see, monkey do. But if the view from the trees trees, deals are decidedly still being done, debt is available, and at least some are sounding remarkably laid back about it all.

“What has changed basically is that debt was cheap in the spring and got more expensive,” says Thomas Kubr, CEO of Capital Dynamics, the global, private equity asset manager that currently has over US$20bn of funds from institutional investors placed in more than 550 private equity funds worldwide.

“We have not seen a private equity bubble bursting. All we’re seeing now is the end of a really fantastic period going back to normalcy.”

Ah. ‘If you can keep your head when all about you are losing theirs’…etc. So are investors not concerned?

“We have been on the record for the last 18 months as anticipating this would happen. We also discussed with our clients that this would happen. And now that it has happened, we spend a lot of time discussing the full context so that they can communicate effectively with their constituents.”

The situation as he sees it is: “If you want to buy a company right now, there is debt available at interesting spreads. We’re not talking meltdown. We’re talking about debt being back to a level that we saw about two or three years ago, and even then it was at an historic low.”

One head of a large LP, who wished to remain anonymous, said that while it was a time to wait and see, he did not expect to commit much less this year, and that any dip would be more to do with the cycle than RVU.

Kubr shares such optimism: “We commit about five to seven billion [dollars] a year and don’t see that number shrinking.”

He points out that while lower returns are inevitable, it does not mean that private equity will lose its edge over public equity. “We have discussed the situation in depth without clients over the past few weeks and find them sharing our fundamental view.”

He defines the floor on returns as public market return and says private equity should aim to outperform that by 4% to 6% per annum.”

Sam Robinson, director of private equity at SVG Capital, a private equity investor and fund manager listed on the London Stock Exchange, believes that investors understand the reality shift.

He thinks there is an acceptance that some portfolios are worth less than two months ago, but that they aren’t necessarily worth less than they were reported at before the turmoil. By that, he means that private equity is largely conservative about valuations.

“People understand that investors don’t thank you if you tell them it’s worth three times the money and then only give them two. The average GP that we back is fairly conservative. [As a hypothetical example], maybe they’ve valued something at a 100 in the early summer that they really thought was worth 150 and, actually, now it’s worth 120.”

As for debt, he feels that SVG and its kind are being viewed more favourably. “Banks seem to be taking a different view of what we do as a fund-of-funds, because it’s diversified, it’s relatively safe. What they’re slightly wary of is the plain LBO lending.”

While new mega LBOs are in the deep freeze, and backlogged ones in the chiller cabinet, there is enough debt for deals to keep mouths fed further down the food chain.

In late August, for example, CIT Capital Finance (UK) Ltd announced it had arranged and underwritten £53m of debt facilities to support Rutland Partners LLP’s £51.m acquisition from Alba PLC of Pulse Home Products Ltd, a leading provider of branded goods to the UK home products market, along with some other Alba brands.

CIT provided £53m of debt facilities, while mid-market specialist Rutland invested approximately £25m from its recently raised £322m Rutland Fund II.

The structuring was not straightforward, but it was completed rapidly, starting before the debt market turmoil, continuing throughout it, and being finalised after the initial shocks.

Tellingly perhaps, the price of the debt provided by CIT, largely a mid-market provider of senior and subordinated debt, did not rise over the discussion period.

Graham Randell, senior managing director of CIT Commercial Finance Europe, said this reflected the fact that there was an element of turnaround in the business, and that the level of leverage was ‘very reasonable’.

Randell says CIT is seeing opportunities thrown up by the fact that its debt book is not tied up, putting it in a favourable position at a time when competitors, such as some commercial banks that have been playing both the large and mid-markets, have been hamstrung by senior executives’ caution over sanctioning any scale of deal while their books are full.

“We’re actually also a buyer of paper in the large market, and over the last two or three weeks (to September 7), CIT has bought more than a billion dollars worth of debt at sub-par pricing…95, 96,” he added.

But not at the expense of taking on higher risk. “They’re quality deals where the pricing has gone very low. They’ve typically been backed by cash flow assets.”

Randell reckoned that by early September, around €12bn had built up in warehouse debt as the end result of collateralised loan obligations not being launched. And this, he said, was being pushed back on to the market.

“Because there’s an oversupply of some quite good deals, the pricing keeps coming down. So you can actually get a better price on some good deals than you would do on some not-so-good deals, shall we say.”

Sun shines: make hay

Others are making similar hay while the sun shines on their niche. “We had discussions with LPs,” said Adam Eifion-Jones, managing director of Babson Capital Europe, who is principally involved with mezzanine funds at one of the largest leveraged loan managers in Europe. “I wouldn’t say they’ve been concerned, just more interested. But the actual prognosis for the mezzanine market is pretty good.”

Three months ago, second lien, combined sometimes with PIK, was putting pressure on mezzanine. “[But now] mezzanine in its more pure format is back,” says Eifion-Jones. “And its characteristics are good. Things like the toggles mechanism have gone, pricing’s on its way back up, and because of the liquidity issues on the senior side, the deals that are getting done are as a sort of ‘club’ approach.”

He sees sponsors and banks looking to get subordinated partners on board early in the process, if not at the arranging point, which is good news for players such as Babson, which had an arranging focus route anyway. The timing of the turmoil has helped to endorse that approach.

Eifion-Jones was speaking as Babson worked on three or four such club scenarios for enterprise values between €250m and €500m.

The take-home message is that, at least in the mid-market, there are debt solutions out there. It just might take some shopping around, forging new relationships, and possibly sharing the prizes more widely, even if that raises issues of governance, say on the timing of exits.

For SVG’s Sam Robinson, now is the time that GPs, who have been fretting about the prospect of a sharp correction for two years, will find out how good their assumptions were.

“They were all factoring in multiple decline: [for example] assuming that you are buying a company at eight times EBITDA, you’ve got to make sure it’s making enough money at seven times EBITDA on exit. They’re going to be tested now as to whether their models worked.”

“If you look at the multiples that have been paid, they’re at an eight, nine, 10-year high, and that is not sustainable,” notes Baird’s David Silver. “Some private equity firms have modelled acquisitions on the basis that they will be able to sell the business for at least the multiple that they bought it for. That quite possibly won’t be the case.”

Silver foresees a period of adjustment in vendors’ and buyers’ expectations on valuations. “But I don’t think we’ll see wholesale, huge cuts in prices. I think you’ll see more discipline throughout the market.”

Prices will be underpinned in part, he feels, by the presence of cash-rich trade buyers who have learned how to play the auction game after a few years of losing out to private equity on fleetness of foot and innovation in structuring.

This will apply particularly where trade buyers can gain synergies from mergers and acquisitions, deals for which, in some cases, they are currently being offered lower spreads than private equity. Other commentators have suggested that private equity will have to be more willing to get into bed with trade buyers, if their overtures are not spurned by their erstwhile rivals.

CIT’s Randell lays it on the line over leverage. But first a mild sweetener, certainly compared with talk from the US of mezzanine debt at around 15% above cost of funds.

“When I’ve had my conversations with mezzanine players… the general feeling is that the price is between 9% and 10% over cost of funds and will continue in that range.”

But he adds: “What’s more important to them is that the leverage in the overall deal comes down, and that you end up with a safe deal. They’re more concerned with not losing their money than getting an extra 1% out of the deal.”

Others point out that the liquidity of private equity means there will always be a ready market to sell businesses into and, despite more competition, there will always be situations where returns remain attractive.

But it is clear from these and other responses that lower returns and pressure on valuations will demand more innovation, harder work on improving the management of companies, maybe a fresh look at fees, possibly more collaboration, and a hard look at where firms are in the market.

“Frankly, the only question for me is, ‘are there too many private equity firms that aren’t differentiated?’” says David Silver at Baird. “Only time will tell I suspect.”

Time is the great imponderable. Seasoned observers such as SVG’s Robinson, smile at forecasts of how long it will take for debt markets to ‘normalise’.

“Everyone’s saying there’s probably going to be no large deals done for the rest of the year, and the question is will it start picking up early next year, or will it be 12 or 18 months. No-one really knows. It’s all pontification really: guesswork.”

But do not write off the headline-grabbing deal forever, chides Capital Dynamics’ Thomas Kubr. “Why should the mega buyout be dead? Do the banks have a backlog to work off ? Absolutely! But what does that have to do with the climate we’ll see in 12 months? I don’t believe we’ll see another mega deal being announced in the next three months. But is it dead because of that? No!”