Strong liquidity drive structural aggression

As investor demand continues to outstrip deal supply across Europe’s leveraged buyout financing markets, sponsors are demanding increasingly aggressive structures. Equity components are plummeting and US features, such as second liens, are pushing up total leverage multiples. Joanna Hickey reports.

Investor liquidity has never been higher across Europe’s senior debt, high yield and mezzanine markets, driven by renewed confidence in the economic outlook and muted M&A volumes, which have left lenders with few other high yielding investment opportunities. “Liquidity is at an unprecedented high across Europe’s senior debt, mezzanine and high yield markets. Given the ongoing lack of M&A activity, banks especially have a lot of surplus liquidity that they need to invest,” says Richard Munn, co-head of European loans at Deutsche Bank.

More and more banks are entering the senior debt market in search of yield, while the number of arrangers continues to swell. The institutional investor base is still rising, with about 25 CDO managers now actively buying leveraged loans. Several CDOs closed in Q1 and are ramping up the remainder of their funds, while at least 12 new CDOs are set to come on line this year, representing over €2bn in new money. Also, since spreads in the US senior debt market plummeted beneath those in Europe last summer, opportunistic US investors have been seeking to join European senior debt and mezzanine financings.

Senior debt liquidity is so high that only a handful of deals, notably Travelodge, Linpac, Brenntag and Invensys, have encountered syndication problems in the past year. Most leveraged loans are blowing out in syndication. Even traditionally less favourable sector credits are routinely closing oversubscribed, as Debenhams illustrated in size in Q1.

Meanwhile, investor appetite in Europe’s subordinated debt markets is even higher. Mezzanine, especially, is swamped with investors jostling to break into or maintain their position in the market. As well as the traditional and newer specialised funds, banks, CDOs, pension and insurance companies, US investors have tried to enter the market, since spreads in the US senior debt and second lien markets started to plummet last summer. US hedge funds such as Amaranth and Cereberus are cropping up increasingly, while other US funds and asset managers are also trying to buy European mezzanine. European high yield is enjoying a similar bull market; LBO yields have dropped to 8% and, as investor liquidity soars, ever larger all-Euro transactions are being placed, culminating in Seat’s €1.3bn issue in April, Europe’s largest ever.

Structures pushed to the max

Sponsors are exploiting the voracious investor appetite to the hilt by demanding increasingly borrower-friendly financing packages. Banks, desperate to win mandates and confident of syndication capacity, are willing to meet sponsors’ demands. In terms of structural aggression, the market is now only a fraction away from the last peak in 1998.

Equity components are plummeting. According to Standard & Poor’s Leveraged Commentary & Data (S&P’s LCD), the average equity component in February was 30.3%, which is the lowest figure since April 1998 and substantially down from May 2003’s 40.2%. Picard Surgeles’ April recap had just 21% equity, although this soon looked conservative against the ensuing Yellow Brick Road directories recap, where sponsors 3i and VSS are withdrawing 100% of their equity.

Meanwhile, leverage levels are soaring. In February, the year-to-date average total of debt to EBITDA multiple for initial LBOs was 4.65x, less than half a turn under the 1997/1998 market peak, according to S&P’s LCD. Free cash flow when capital expenditure and working capital are stripped out reveals today’s structures to be even more aggressive; total debt to EBITDA minus capex has shot up from 5.5x in 2003 to 6.1x in 2004 (S&P’s LCD.)

Fixed charge, or debt service cover ratios are also being eroded. Although the fixed charge ratio is still not under the 1.2x levels seen in 1998, it has slipped to 1.3x, from 1.4x just a year ago. “Debt service cover ratios are generally tighter, as reflected in lower ratios of EBITDA minus capex to interest,” says Munn of Deutsche Bank.

Recaps and secondary buyouts are driving forward the trend for aggressive structures, as credit familiarity and proven performance persuades lenders to countenance higher multiples and lower equity for these deals. Similarly, lenders will accept low equity percentages if the overall quantum of equity is significant. However, while last year aggressive structures were mainly confined to these types of deals, distinctions between credits are now blurring. First time LBOs and weaker, more cyclical sector credits are also now achieving aggressive structures.

Most alarmingly, today’s stretched structures have coincided with a sharp decline in credit quality. Single B volume for LBOs was 50% of all deals in the second half of 2003, a dramatic rise from 26% for 2001 and 2002 (S&P’s LCD.)

Even worse, structures look set to deteriorate even further: 25% equity has become the bidding norm and bankers say it is only a matter of time until more deals come out with 20% to 23%. More and more deals are being bid at over 6x total debt to EBITDA. Following the 5.8x total debt on Picard Surgeles, Yellow Brick Road launched with 6.6x total and 4.7x senior debt, Grohe’s recap is being bid at over 6x total debt and Labeyrie’s recap is rumoured at 6.3x total debt.

Lower yielding debt

The subordinated debt markets have borne the brunt of today’s soaring debt multiples. By February, sub-debt had shot up to 1.1x EBITDA from 0.7x in 2003 and 0.8x in 2002, 2001 and 2000, according to S&P’s LCD. Mezzanine tranches are expanding, with €500m now deemed feasible, while the high yield market is also absorbing ever larger issues, as Seat illustrated conclusively.

In addition, new, cheaper forms of subordinated debt have emerged, such as second lien loans. Although second liens are a regular feature of the US market, before this year Europe had only seen a few, notably Cantrell & Cochrane’s refinancing in 2002 and Premier Foods’ small add-on facility last year. However, two European second liens appeared in the first quarter, for Brenntag and Invensys, and bankers expect more to emerge in the coming months. Seat’s four arrangers underwrote a €150m second lien, although this was taken out by the bond in April and was not syndicated.

Like Cantrell and Premier Foods, Brenntag and Invensys were second secured and entirely cash-pay, sitting below senior debt and above mezzanine or bonds in the capital structure, with the latter demoted to third secured cash-pay debt. Priced at 4.5% to 5.5% over Libor compared to mezzanine’s 14% to 16% all-in IRR and high yield’s 8% to 9% plus call penalties, these new US-style second liens allow sponsors to reduce their equity with far cheaper, longer-dated debt.

Both second liens were aimed at institutional investors in Europe and the US. Banks are not natural buyers as they either prefer the top ranking position of senior debt, or, if they buy second ranking paper, seek the higher yield of mezzanine. Meanwhile, mezzanine and high-yield investors find second lien far too low yielding. Ultimately, both Brenntag and Invensys were placed almost entirely with US institutions, with only about a handful of European CDOs electing to join.

US institutional and hedge fund appetite for European second liens is substantial at present. US institutions are not only highly liquid, but are very familiar with the instrument, due to the burgeoning US second lien market. However, appetite for the paper among Europe’s institutions is less certain. Some European CDOs view the product as stretched senior debt and therefore, as it yields about 150bp more than senior debt for usually less than half a turn more leverage, as good relative value. These investors would buy future second liens if the credit was strong, the leverage no more than 0.5x and if a sizeable bond or mezzanine sat below it.

However, other European CDOs view second lien as ‘underpriced mezzanine’ and, consequently, as unattractively priced for the risk, even though it lends through less leverage than either high yield or mezzanine. Such CDOs are unlikely to buy it, as it would involve using up their mezzanine buckets with a far lower yielding asset. “As second lien loans have a junior ranking, many European CDOs have to book them as mezzanine, which uses up their baskets. And at 450 to 550bp over Libor, second lien returns then look unattractive relative to traditional mezzanine at around 11% over Libor,” says Richard Howell, head of leveraged capital markets, Lehman Brothers.

But whether or not European CDOs warm to second lien, it seems unlikely to become a permanent feature in Europe. Europe’s CDO market alone is not big enough to warrant the development of such a structure, while banks, mezzanine and high yield investors are not natural buyers and other investors, US hedge funds and institutional investors, are deemed short-term and opportunistic.

“Second lien is not really a European product, it is primarily driven by US institutions that view the relative value between historically low senior and high yield returns as attractive. This calls into question whether the product will still be around when US spreads rise and the relative value play falls away,” says Howell.

The few second liens seen in Europe can also be viewed as the result of senior debt syndication problems, rather than a strategy to introduce another form of debt into the market. Cantrell and Brenntag’s second liens were only added after senior lenders baulked at the hefty senior leverage. “The few second liens we have seen in Europe were more a result of difficulties in selling the senior debt in its original form,” says James Davis, assistant director at ICG.

For mezzanine investors, which could not only find their supply drained if second lien took off in Europe, but are also bumped down to third ranking, the product poses a potential threat. While mezzanine investors are lending through almost the same leverage for a small second lien, if larger deals were to appear, their risk position would increase greatly. However, most mezzanine investors remain sanguine about the product, as they too feel it is a temporary one. “We would expect to have a greater return for a third ranking position compared to the usual mezzanine pricing. The blended pricing across the capital structure may cancel out the cost savings the sponsor made from including the second lien, which is one of the reasons we don’t see it becoming a routine market feature,” says Christine Vanden Beukel, managing director at GSC Partners.

More aggression

In addition to lower-yielding sub-debt, rising multiples and falling equity, a slew of other aggressive structural features has emerged over the past six months. Documentation and financial covenants are loosening, with far more latitude given for poor performance. “Investors are allowing sponsors greater flexibility to more actively manage both the acquired business and their investments in that business on an ongoing basis. This flexibility is evidenced by increased covenant headroom and a more relaxed approach to the payment of dividends from asset disposals, among other factors,” says Vijay Rajguru, head of leveraged loans at Barclays.

Cash-sweeps and disposals are being used to give dividends to sponsors before debt is repaid, while capex facilities are being pushed out from two years to three and even four in some cases. Restrictions over future events such as IPOs, which previously required lender approval or repayment, are also being lifted. “Increasingly, structures are being seen that envisage a wider range of potential options for the business, management and equity investors down the road, such as bolt-on acquisitions and an IPO, than has historically been the case,” says Rajguru.

In addition, although senior debt headline spreads remain static as banks, which are more credit than pricing focused, still represent 80% of the leveraged loan market, pricing grids are on the rise. Term loan B ratchets have become the market norm over the last year and term loan C ratchets are now anticipated.

Arrangers are differentiating more between senior debt investors through fees. While bank upfronts remain static, CDO fees have plummeted from the traditional 50bp to closer to 10bp to15bp this year. Funds are even accepting zero upfronts; Clondalkin’s fund carve-outs were hugely oversubscribed, despite the paltry 12.5bp upfront, while IMO, Sulo and the re-cut Linpac carried zero fund upfronts and Baxi only paid fees for the bigger ticket CDOs.

Meanwhile, pricing in the high yield and mezzanine markets is plummeting. Although high yield pricing has always fluctuated in line with investor liquidity, this is a newer development for mezzanine. The growing diversity of funds that dominate the mezzanine investor base has made the market more sophisticated than its senior debt counterpart and pricing is starting to converge with high yield. As bond pricing has fallen to 8%, so mezzanine pricing has dropped to 11% and even 10% for some deals, with transactions such as OGF at 11% still raising huge oversubscriptions.

Concerns intensifying

Although structures seem to be stretched to the limit, bankers say even more aggressive deals are on the way. “Most people feel that we have not reached the top of the market yet. Other deals are on the way with even higher leverage, lower equity and more aggressive documentation,” says Howell of Lehmans.

Some bankers still argue the quality of businesses being bought out remains very high and that strong credits can cope with aggressive multiples. This, added to the fact that the economic environment is more favourable today compared to 1998 and that interest rates remain low, means companies’ ability to service interest is still comparatively robust, helping to mitigate the likelihood of defaults down the line.

However, with the threat of even more aggressive transactions looming large, concerns first voiced by some bankers last summer that the market is overheating are intensifying. Bankers are increasingly worried about waivers and defaults on the horizon, especially for more cyclical companies. “Broader trends, such as rising oil and commodity prices, will have a negative impact on certain industrial credits,” says Munn of Deutsche.

So what will stop the seemingly relentless wave of aggressive transactions? If the US market cools off, it will take some heat out of the European market and at least stop leverage increasing further. Rising interest rates will also reduce companies’ ability to service debt, especially if top-line growth does not rise in tandem. Also, following the bumper first quarter, most banks are in line with their budgets, which will make them feel less compelled to support overly aggressive transactions. Linpac, which was pulled from the market last year, showed there is a line senior lenders will not cross, especially if cash flow cover is low and capex high. Had Linpac not had recourse to the fortuitous asset disposals that reduced overall leverage to a satisfactory level for re-syndication, the initial failed syndication would have had far more of an impact on the market.

However, while such factors could cause leverage and equity levels to plateau, it will take a more dramatic event to shift them in the opposite direction. An external shock, such as a downturn in the US, a deterioration in the Iraq situation or an M&A revival giving banks alternative investment opportunities, is required for a more conservative tone to prevail. But barring such an event, bankers expect LBO financing structures to remain ultra-aggressive for the rest of this year. “Structures will only become more conservative if the boundaries get defined by more high-profile syndication problems or if there is a wider exogenous credit event that impacts liquidity,” says Howell.