European private equity funds have broken fundraising records in 2005. Fuelled by a ready and willing debt market, they have been able to buy bigger companies with cheap financing and have stretched the LBO market to the next level. But competition from trade buyers is returning and there are signs that lenders' appetite may be weakening for certain types of deals. Taron Wade asks how private equity houses plan to make returns on their new multi-billion funds.
Armed with a ready supply of debt, private equity funds in Europe have enjoyed a clear run at businesses over the past few years, as trade buyers largely sat on the sidelines nursing their balance sheets back to health. But this year, industrial companies have begun to make a comeback on the acquisition trail.
In April, engineering group Siemens swooped in and bought Flender, the German gear maker, from under the noses of private equity sponsors that had spent months working on bids.
And in July, France Télécom purchased 80% of Amena, the mobile assets of Spanish telecommunications company Auna. Two groups of private equity firms had been labouring on that deal and were caught off guard when the prize went to a trade buyer.
"Trade buyers are now starting to pay more for companies," says Steve Swift, head of European loan syndication at SG CIB in Paris. "It's not only leveraged lenders that are driving up prices."
Many companies have spent the past few years retrenching and delevering their balance sheets — now they are looking for new vehicles for growth.
"We are very watchful of trade buyers," said one private equity official at a European buyout firm. "A key part of our bidding process is working out if we are wasting our time."
But other sponsors are not as concerned. "Private equity firms still have a competitive advantage," says James Stewart, a director at ECI Partners, a London based private equity house. "Sponsors can do a deal rapidly and their core activity is investing. They also have an ongoing and active dialogue with providers of debt."
Andrew Burgess, managing director in the Carlyle Group's European buyout team in London, agrees: "Private equity houses pay cash and often back the incumbent management teams. We can also restructure and grow a business faster than corporate buyers."
And trade buyers are not new competitors for sponsors. "It is quite a competitive marketplace," says Marco Herbst, associate director at Duke Street Capital in London. "Trade buyers have already been active this year — various companies have been sold to trade buyers — so I think it's already been factored in."
The interest of trade buyers can be a double-edged sword. They are competitors for buying companies, but when it comes to exiting investments, sponsors need them to be there.
Private equity houses' ability to stay competitive will depend to some extent on banks' readiness to provide debt. If banks pull back from the leveraged loan market, corporate borrowers could gain an advantage when buying companies, since they can use the entire breadth of their balance sheets to support acquisition finance.
Keeping the edge
The competition in the market is not making it easy for private equity funds to source deals. They have a lot of money to put to work and keeping it in cash is not an option because of the returns their investors demand.
It is hard to tell, however, whether private equity sponsors will be able to maintain their returns in this type of environment because of their investment horizon.
"It is a medium to long term game," says Herbst. "If you raise a fund today, you will really only know in four or five years' time."
Herbst acknowledges that prices for companies are currently high, and says the key challenge is to develop an angle on a deal: "Either it's a build-up opportunity, a sector you know well or you have great management contacts in that sector."
Valuations are so high that when sponsors come to sell the investments they are making now, they might not be able obtain the same multiples they paid.
"Selling a company for less than the multiple at which it was purchased means that Ebitda must grow," says Swift at SG CIB. "If the economy doesn't generate growth — which is likely — then either fat needs to be cut or market share needs to be grown and it's hard to do both at the same time."
But sponsors insist they are conservative when buying companies. A director at a European private equity house in London says his firm used to use a model in which its most conservative exit option was selling a company at the same multiple of Ebitda at which it was purchased.
"We've changed that to take the toppy debt market into account," he explained. "We now use a model with the most conservative estimate assuming we can only sell a business for a lesser multiple. For every additional multiple, we know we need to grow Ebitda by an extra amount."
Burgess at Carlyle also argues that private equity is not yet in the grip of the law of diminishing returns.
"If the asset class gets overinvested then returns will come down," he says. "But then again, there are opportunities to acquire businesses on a global scale and restructure them, like Hertz. Yes, there is more money to invest, but businesses are bigger."
Private equity funds insist that opportunities in Europe abound — that there are plenty of places to mine for businesses in need of restructuring and growth.
"The restructuring of corporate Europe continues at various speeds — one of those sectors is the automotive industry," says Burgess.
Retailers are suffering from a slowdown in consumer spending, and some of those companies may make good investments if private equity houses can buy at the bottom of the market.
But one buyout specialist warns that low valuations do not always mean those companies are good opportunities. "If you buy a bad business cheaply, it doesn't make it a good business," he says.
Some financial buyers are concentrating on niche markets to stay competitive.
"We focus on mid-market deal flow because we can have more proprietary business," Stewart at ECI says. "By not syndicating deals to other sponsors, it gives us more flexibility, particularly if an investment doesn't perform to plan."
What most sponsors agree on, however, is the need to be fleet of foot to stay ahead of the game. "Quality managers will be the ones able to raise funding," Burgess adds. "Because businesses are bought at such a high level, sponsors need to be proactive."
Epic fundraising, epic deals
Earlier this year it became apparent that private equity funds were beginning to set their sights on bigger targets — both for investments and fundraising. At the same time as bidding was going on for super-jumbo transactions, such as Italian telecoms firm Wind and Spanish telco Auna, BC Partners announced a new Eu5.8bn vehicle and Goldman Sachs raised an $8.5bn fund.
The Blackstone Group revealed at the end of October that it had raised the largest private equity fund, at $10.3bn with a final target size of $12.5bn, and CVC Capital Partners is believed to be raising a fund with a target closing size of Eu6bn. Kohlberg Kravis Roberts said in late October that it had raised Eu4.5bn for its second European buyout fund.
There is no way all this money could make the returns investors expect without the substantial growth of the debt market, which has allowed sponsors to do larger buyouts than ever before in Europe.
Although it was not strictly led by private equity funds, the record-breaking Eu12.138bn purchase of Italian mobile phone company Wind injected excitement into the market, as it more than doubled the record for a leveraged transaction in Europe, set by the Eu5.7bn Seat Pagine Gialle deal in 2003.
A consortium called Weather, led by Egyptian entrepreneur Naguib Sawiris, bought Wind from Enel, the Italian utility firm, but the deal hit rough waters. At the end of syndication each of the three bookrunners was left long by as much as Eu1bn.
But the transaction changed expectations for the capacity of the leveraged loan market in Europe. Most agree that the debt now available — which made bidding for Wind possible — is here to stay.
Indeed, the new money piling into the European debt market has mostly been invested for the long term. Although some hedge funds — which are typically just relative value players — have come into the European market, their presence has been exaggerated.
US money managers have opened offices in Europe to become long term players in the region, and European collateralised loan managers have expanded the number and types of fund they manage that invest in the LBO market.
Sankaty Advisors, a Boston-based credit fund manager with $12bn of committed capital that has been investing in the European market since 1998, moved two people to London this summer to open an office.
"We think Europe now presents an excellent opportunity," says Jonathan Lavine, Sankaty's chief investment officer in Boston. "Until recently, we felt we could manage credits globally from Boston and wait to put people full time in London until there was enough activity. If you take a look at the European institutional market, three years ago 23% of LBO debt transactions were absorbed by institutional investors. Today that number has reached 50% and is growing."
The limits of the debt market
But the supply of debt is not limitless. The leveraged loan market climbed to a peak of demand in around March or April this year. Even the most difficult transactions were being snapped up. A deal for Rexel, the French electrical parts manufacturer, achieved multiples that it would not have obtained later in the year, according to leveraged loan bankers. The transaction was syndicated in February and March with senior debt of 5.1 times Ebitda and total debt of 6.7 times.
As summer approached the pipeline of expected transactions swelled steadily and lenders had little time to look at everything in syndication, meaning that they quickly turned down deals that were in any way challenging.
In late July, deals for Pirelli Cable, SigmaKalon, Partners in Lighting and British Vita suffered because of the glut of transactions lenders were able to choose from.
And now that some investors' portfolio companies — such as German fittings manufacturer Grohe, Finnish bathroom maker Sanitec and German car parts producers Honsel and Edscha — are experiencing tough trading conditions or have breached covenants, investors are becoming more skittish.
"Liquidity is strong, but not uniformly so, which results in greater discernment from investors, who will not hesitate to pass if the risk/reward equation doesn't work for them," says Chris Baines, head of loan distribution at SG CIB. "That's why some deals are being flexed up and are struggling and others are reverse flexed and oversubscribed. But this is a sign of maturity and should be viewed as good news for the market as a whole."
Although there is much more cash in the market than in the past, there is a sense that leverage has gone too far and there will be a fall-out.
For example, private equity funds are not necessarily accepting all the debt that is offered to them.
"Over the past 12 months, deals are being closed with less debt than has been offered," says Carlyle's Burgess.
This concurs with a survey published by Close Brothers Corporate Finance in October, showing that 90% of mid-market private equity funds were taking less debt than was offered to them.
"It is a cyclical industry," says Greg Lomas, head of loan underwriting and distribution, Europe, at CIBC in London. "At some point the music has to stop. Right now leverage is one turn higher than it should be, across the board, and documentation in some respects continues to weaken."
Perhaps at some point sponsors will start to take covenant packages less accommodating than banks are offering. That might be a true sign of maturity in the market.