Investment grade in need of M&A

  • 11 Mar 2005
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Borrowers rule the European investment grade syndicated loan market and they are unlikely to loosen their grip any time soon. Margins and fees are approaching all time lows, covenants are becoming collectors' items and tenors are stretching out to seven years and quite possibly even beyond. The only saviour for lenders would be the return of big-ticket M&A deals. Fortunately for them, they could be just around the corner.

For lenders in investment grade land, 2004 began so well, with the announcement in January of the Eu48bn hostile bid by France's Sanofi-Synthelabo of the Franco-German pharmaceuticals company, Aventis, which was partly financed by a jumbo Eu16bn facility signed in July.

At the same time as news of the Sanofi-Aventis bid surfaced, excitement was also building about a jumbo bid for AT&T and about the potential for an acceleration in M&A activity in sectors ranging from European utilities to retailing and banking.

Thereafter, although there were isolated transactions such as Bacardi's acquisition of Grey Goose Vodka, the floodgates stubbornly refused to open. Certainly, the Eu12bn facility unveiled late last year by Telecom Italia to finance its Eu20bn purchase of the remaining 44% stake in Telecom Italia Mobile that it did not already own helped to resurrect hopes that big-ticket M&A activity in Europe is on the cusp of a revival. So too did Xstrata's announcement in November of its Eu4.4bn hostile bid for Australia's WMC Resources.

On balance, however, there is no escaping the fact that 2004 was a miserable year for M&A financing. "M&A financing was very slow for most of 2004, but the end of the year showed encouraging signs of a pick-up in activity which we hope will continue in 2005," says Kristian Orssten, co-head of syndicated loans at JP Morgan in London. "2004's acquisition financing volume was dominated by a handful of large deals totalling about $75bn, which is still a far cry from the $200bn in 2000."

As a result, the recent past has been dominated by refinancings, with bankers saying that no more than about 20% of the facilities launched last year in the European investment grade market could be classified as so-called 'new money' transactions.

"Because there has been so little demand for new money, and very little event-driven financing for investment grade corporates, banks in search of volume in the loan market have turned to their customers' existing facilities and offered to fine-tune pricing," says Stein Melsbo, managing director of global loans at Dresdner Kleinwort Wasserstein (DrKW) in London.

Plummeting margins
An inevitable by-product was that pricing, already under acute pressure in 2003, continued to fall in 2004. The process has been a pan-European one, with scarcely a month going by without borrowers in one region or another pushing through new pricing benchmarks.

Scandinavian borrowers have been relentless in their pursuit of lower prices, with issuers such as Fortum and Stora Enso completing facilities towards the end of 2004 at well below 30bp, compared with the low 40s for previous deals.

In France, meanwhile, Carrefour provided a graphic example of the bargaining power enjoyed by corporates in today's market. Its $1.5bn five year revolver offered a razor-thin 17bp over Euribor, compared with the 25bp the same borrower paid for its Eu1.5bn facility with the same tenor signed in 2003.

In Germany, lenders' response to E.On's jumbo two-tranche Eu10bn refinancing facility signed in December last year was also symptomatic of the pan-European trend.

The E.On transaction, which refinanced a Eu7.5bn one year facility raised in 2003, paid margins of 15bp and 20bp over Euribor for the one and five year tranches, which compared with 20bp over Euribor for the previous year's loan. In spite of that reduction, the E.On deal generated demand of Eu15bn.

The jury is out on whether pricing can be pushed even lower in 2005. "In this environment it seems almost as though each week people are successfully knocking basis points off the price point that was reached the previous week," says Orssten at JP Morgan. "So everybody is asking themselves how far pricing can be pushed. Common sense suggests that at some point we will reach a rock bottom level. Pricing will stabilise when individual client profitability is eroded to such an extent that it is no longer viable."

Orssten thinks the market may be close to reaching that point. "Banks are now considerably more conscious of their profitability and of the need to deliver shareholder value than they were a decade or so ago," he adds. "Their return models have generally become more sophisticated than they were in the mid-1990s, and lenders are therefore better positioned to evaluate individual clients' overall profitability — not just over a single year but over an entire cycle. This is leading to a recognition that in today's competitive environment, the investment grade corporate franchise is not particularly profitable for most banks."

While that recognition may help to put a brake on the speed with which prices are falling, lenders are not betting on it, given the continued over-capitalisation of the banking sector and the torrent of cash that is still looking for a home.

But it is not just banks' liquidity and pursuit of league table status that has strengthened borrowers' bargaining power in the investment grade echelons of the syndicated loan market. "Because there is so much information available on the market, and because a much higher proportion of borrowers in Europe are rated now compared with 10 years ago, there is something close to full transparency in terms of where pricing should be in the loan market," says Melsbo at DrKW. "That makes it easier for corporates to compare themselves with their peer group, which in an environment of falling pricing makes it easier for them to drive their own pricing lower."

Global slide
In tandem with the continued decline in pricing, recent months have also seen a precipitous fall in commitment fees in the investment grade market in Europe. Tim Ritchie, head of global loans at Barclays Capital in London, points out that the reduction in commitment fees has been an especially significant development in an environment in which so many facilities inevitably remain undrawn. In the case of Carrefour's $1.5bn five year revolver, for example, the borrower was able to halve its commitment fee, from 10bp on its similarly-sized facility signed in 2003 to just 5bp in 2004.

The savage paring of pricing has not been confined to facilities from EU-based borrowers. Banks starved of new lending opportunities in western Europe have increasingly been looking to the next wave of potential newcomers to the EU in search of enhanced returns, with recent transactions from modestly rated borrowers such as HBOR of Croatia generating cascades of demand from yield-starved lenders.

Beyond Europe, pricing has also been on the slide. 2004 was the busiest year in the Asian syndicated loan market since 1997, but that did not stop pricing falling to a seven year low. Top quality regional borrowers were able to get relationship-based five year facilities away at prices in the 30bp-40bp over Libor region, compared with as high as 85bp-100bp for similarly rated borrowers two years ago.

In the US investment grade market, too, pricing has been under pressure in recent years. "A supply-demand imbalance has been created in the US market over the last few years, with very little demand for new loans to fund M&A or new business investment," says Jeff Stuart, managing director and head of loan markets for the Americas at RBS in New York. "That supply-demand imbalance has certainly shifted the balance of power to the borrower in the US, just as it has in Europe."

Over and above the downward spiral in pricing, there have been a number of other telling indications of the extent to which the balance of power in the investment grade market has moved from lenders to borrowers.

At RBS, managing director and head of European corporate loan markets Declan McGrath points to the way in which the $5.8bn funding supporting the acquisition of RMC by Cemex was structured as an example of the bargaining power now enjoyed by borrowers. "In the Cemex deal we saw the lead banking group turn the sub-underwriting phase into an auction, with the first 11 banks taking the senior tickets and the senior fee," he says. "We may see more of that sort of procedure, reflecting banks' desperation for assets."

Vanishing act
While pricing and fees remain under pressure, covenants appear to have disappeared from investment grade land altogether. "I can't remember when I last saw anything in triple-B land or above with a financial covenant," says Julian van Kan, head of loan syndications and trading at BNP Paribas in London. "Whereas three or four years ago financial covenants were the norm, they are simply no longer a feature in the market."

Van Kan is far from being alone in saying that he is sorry to see financial covenants go, although he concedes that there is some doubt about how effective they were because they were so seldom enforced. "Financial covenants effectively acted as bellwethers," he says. "When borrowers came anywhere near breaching them we tended to adjust them anyway."

Bankers appear to doubt that the dismantling of covenants is purely a cyclical feature. "I'm not sure that it will be easy to return to the protection levels that we have traditionally enjoyed as lenders," says Stephen Swift, head of European loan syndication at SG CIB. "Now that a number of golden calves have been slaughtered it will be an uphill task to persuade borrowers that covenants are indispensable. In doing away with covenants and in weakening documentation, as lenders we now find ourselves in a closer position to bondholders without enjoying the advantages of liquidity and price transparency that bondholders have."

"We are already starting to see some fairly silly things happen on the documentation side of loans," adds Swift. "Bankers need to ensure that reducing or eliminating covenants and in some recent cases the watering down of change of control provisions are justified by the credit quality of the counterparty. The combination of those factors could mean that the underlying credit quality of the borrower could change radically without banks being able to reassess their exposure. There's obviously potentially a problem there."

Other pressures are being brought to bear on documentation in the investment grade arena. The Material Adverse Change (MAC) clause, for example, appears to be in danger of becoming an endangered species for the better rated borrowers, in part because ratings agencies are increasingly pressurising companies into removing MAC language from their loan documentation. "I would not be interested in an unrated company that wanted to get rid of its MAC language," says van Kan. "But I think every bank now accepts that MAC is increasingly having a negative impact on ratings. Only the other day I was talking to a borrower with an A+ rating which has been told by the ratings agencies that it will need to lose its MAC if it wants to be upgraded to AA-."

As with financial covenants, there is little on the horizon to suggest that documentation is likely to be tightened in the future. "From a documentation perspective everything seems to be going in favour of the borrowers at the moment," says one banker. "Normally you would imagine that one negative credit event of a significant size would be enough to reverse that trend. But having said that, the liquidity that is circulating in the market at the moment meant that events such as Parmalat, the Madrid bombing and the Iraq war had no impact at all on documentation procedure in the loan market."

Investment grade levels out
At a broader level, the disappearance of covenants and the weakening of loan documentation in general appears to be symptomatic, say lenders, of a market that is becoming increasingly unable or unwilling to evaluate and price risk for investment grade borrowers effectively.

Van Kan says that a conspicuous trend in the market over the last 12-24 months has been an increasing failure to differentiate between credit ratings. "The market seems unwilling to recognise that there is a huge difference between a single-A and a triple-B minus credit," he says. "More and more, the borrower seems to equal the borrower, irrespective of its credit quality."

Another trend that highlights the degree to which the loans area has become a borrowers' market has been a drift towards self-arranged transactions. "Corporates have been winding down the size of their banking groups, saying that rather than having 30 banks in a syndicate they can more easily deal with 15-20," says DrKW's Melsbo.

"But borrowers have also recognised that they are best positioned to define which those 15-20 banks should be. So we have a trend towards self-arranged deals in the sense that rather than go out to a broad universe of 100 banks to see which ones have an appetite for their deal, borrowers are targeting their banks very carefully."

As a consequence, says Melsbo, bookrunners in the investment grade space are increasingly playing an administrative role, rather than discovering new or untapped sources of funding for their customers.

Seven is the new five
Beyond covenants and documentation, there are several other ways in which borrowers are enjoying an increasingly firm grasp of the whip hand in today's investment grade market. Take the recent extension of tenors in the market, which in the first half of 2004 started to manifest itself with borrowers such as Nestlé, Vodafone and France Télécom converting existing one year deals into five year facilities. And the early months of 2004 also saw a number of borrowers aggressively challenging the assumption that the five year maturity constitutes some kind of predefined ceiling in the loan market. Seven, in short, seems to be becoming the new five.

The process, say bankers, began to gather momentum early in 2004 with the Eu4.5bn five year refinancing deal for the split A2/A- rated Suez which featured extension options of one year at the end of years one and two, a structure later replicated by borrowers such as Axa and Wolters Kluwer.

Other borrowers pushing into new territory in terms of tenor, meanwhile, included France's Banque PSA which chose a six year tenor for its Eu3bn facility in the summer of 2004, although that unusual maturity did not prevent the transaction from closing heavily oversubscribed.

"Five plus one plus one deals seemed to become the norm quite quickly after the Suez transaction," says van Kan at BNP Paribas. "Some people are concerned that the five plus one plus one structure loosely translates into a seven year facility, especially in the case of close relationship transactions, because it is highly unlikely that any relationship lender is going to say no to an extension after the first one or two years. That means bankers are effectively locking themselves into seven year relationships for five year returns."

A number of bankers say they are more relaxed about the extension of tenors than they are about current trends in pricing, covenants and documentation. "I'm not sure that your visibility in a five year facility is any better than it is in seven years," says one banker. That perhaps explains why there has appeared to be so little resistance to the arrival of straight seven year facilities, with last year's Eu2.5bn refinancing for Philips something of a watershed.

Although pricing on the Philips facility was in line with the more general trend in the market — sharply down from the margin on the electronics giant's original five year loan — van Kan suggests that the strength of demand for the deal points to an increased acceptance of lengthening tenors among relationship banks. "We did not lose a single bank in syndication on the Philips deal," he says. "A year before, the seven year structure would have been much less palatable for refinancings."

Whether or not borrowers will stop at the seven year tenor, or attempt to push beyond that ceiling is open to debate, although lenders suggest this might be a step too far. "I was asked the other day whether we would start to see 10 year bullets," says Charles Pelham, head of syndicated and private debt, international, at Bank of America in London, "but that's something I can't see lenders agreeing to. The credit people who have worked through previous cycles wouldn't agree to that."

Others appear to agree, believing that especially in the case of funded facilities there will be less pressure on tenors than the recent trend for seven year facilities would suggest. "I don't see much reason why many borrowers should want to raise funded facilities out to seven years and beyond," says Melsbo at DrKW. "And if they do, banks will resist, saying that tenors of that kind are really ones that can and should be taken care of by the debt capital market rather than the banks."

That may be. But more generally the apparent powerlessness of banks to counter the remorseless shift in the balance of power away from lenders and towards borrowers in investment grade territory would be mystifying to investors in other asset classes who have been able to take more concerted action in response to dwindling returns.

"If we wanted to take a firmer stance we probably could," says one banker. "But as ever, the problem would be the intense competition between the banks. If 20 of us were to sit down one morning and agree that pricing should go up by 10% this year we would know that only four of us would win the MLA mandate for the next deal. The other 16 would then back out of any agreement on pricing. Competition will dictate that winning mandates and therefore winning access to cross-sell opportunities continues to be the main driver of pricing and documentation."

No going back?
If that suggests that investment grade lenders are unlikely to win anything back as regards of pricing and terms in 2005, there is more bullishness among banks about the prospects for activity in the primary market over the coming months, although whether or not refinancing has now run its course is open to question. "When you think that something like 39 of France's CAC-40 companies refinanced existing facilities in 2004, it is hard to see them coming back again in a hurry, even if they might save a basis point or two in the process," says one lender.

Others are less sure. "Many of the deals done last year had one year components which will either need to be refinanced or reviewed in 2005," says Orssten at JP Morgan. "There are also a number of regions that were less active than others in the refinancing market last year, such as the Nordic region where I think we will see some early refinancing activity in 2005."

Orssten adds that regions such as France and Germany, which were busy in 2004 are likely to be quieter in terms of refinancings in 2005, which he argues may be no bad thing. "In some respects, a reduction in the number of corporate refinancing facilities will allow us to focus on areas that are more lucrative for our franchise," he says.

Real optimism for M&A
In an ideal world, those more lucrative opportunities would be associated with a resurgent M&A market, and in spite of all the false dawns of 2004 lenders say they are hopeful about the outlook for 2005.

Bankers who are optimistic about the prospects for a revival of global M&A will, for example, have taken heart from the Procter & Gamble/Gillette merger announced in January.

David Bassett, managing director and head of global loan markets at RBS in London, points out that reports have suggested that the P&G acquisition of Gillette has initially been constructed as an all-share deal. "But there will be a special dividend which will effectively make about 40% of the deal cash, and 40% of $57bn is not a small number," he says.

"We're not yet sure about how much of the P&G/Gillette transaction will ultimately be financed through the loan market," Bassett adds. "But obviously companies like Nestlé and Unilever will have sat up and taken notice that one of their principal competitors has just become much bigger and increased its pricing power." Ergo, the thinking goes, the P&G/Gillette transaction ought to encourage a fresh wave of consolidation in the consumer goods sector.

But even before the P&G/Gillette announcement, bankers were arguing that the corporate landscape is now ripe for a fresh bout of consolidation. "The fact is that most CEOs have spent the last three years doing very little other than disposing of non-core businesses, tightening up their balance sheets and cutting costs," says McGrath of RBS. "That means that companies should now be ready to start looking for transactions that will deliver synergies and enhanced value for their shareholders three or four years down the line. Deals like Xstrata's bid for WMC, and Travis Perkins, suggest that there is a greater willingness among CEOs to look for growth opportunities via acquisitions, and I think there will be more to come."

Other lenders share this optimism. "There is no doubt that the industry — including advisors such as law and accounting firms — are seeing a significant increase in M&A enquiries, which is certainly a healthy sign," says JP Morgan's Orssten. "Our hope is that those enquiries will turn into deals as confidence returns and CEOs and their respective boards become more willing to pull the trigger."

At RBS, meanwhile, Bassett has good reason to look forward to an upturn in M&A activity this year. "Our pipeline of large M&A financings is already about 10 times stronger than it was this time last year," he says. "That doesn't mean all the deals will happen but I sense that there is much more momentum building up now than there was at the start of 2004, which makes us more bullish than we were 12 months ago."

At Barclays, Tim Ritchie also says he is now more sanguine about the outlook for 2005 than he was in January 2004. "At the beginning of 2004 I was more concerned about the prospects for revenues than I was about the outlook for volumes," he says. "At the start of 2005, I probably feel the reverse. With much of companies' refinancing already done, I think we will see scope for much more interesting and profitable activity this year than we did in 2004."

It is improbable that any of this will mean that acquisition facilities can bounce back quickly to the good old days of 2000, when they accounted for about 45% of activity in the European loan market, but it would suggest that their share can rise from the feeble 12.5% or so that they contributed in 2004.

Just as well, because in the absence of M&A-driven opportunities bank lenders are becoming increasingly twitchy about the outlook for their revenues. "Quite frankly if M&A volumes don't start to pick up again in 2005 I don't see how there will be enough activity out there for banks to have any chance of achieving their budgets this year," says one frustrated lender.

Acquisition premium to reappear?
The multi-billion euro question for bank lenders in the investment grade side of the syndicated loan market is whether or not a re-emergence of big-ticket M&A activity will help to push pricing back up. While some bankers say that for the time being the acquisition premium is a thing of the past, others believe that the re-defining of bank relationships that appears to be gathering momentum may help to reverse the recent sharp decline in pricing.

At RBS, McGrath points to the hypothetical example of a company that has reduced its group of core relationship banks from 30 to 10 institutions, but which needs to raise, say, $7.5bn for an acquisition. That, says McGrath, would change the pricing dynamics of the market sharply, because the banks in the smaller group would be unwilling to sit on commitments of $750m apiece. The only way of distributing a transaction of that size, McGrath adds, would be on market rather than relationship-based terms, which in turn would imply that pricing would need to rise.  

  • 11 Mar 2005

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