A steady flow of new money coupled with a lack of new deal flow is driving recapitalization deals in Europe. Recapitalized credits, which include dividend payouts and shareholder loan repayments, as well as secondary buyouts by other sponsors, jumped from 19 in 2004 to 47 last year, according to a Fitch Ratings study. The trend is expected to continue. "We don't foresee a change in the environment," said Pablo Mazzini, an analyst at Fitch.
The influx of new shops in the European market has driven an increase in liquidity. In 2005, Credit Suisse's Leveraged Investments Group, a part of its Alternative Capital Division set up a shop; GoldenTree Asset Management and Eaton Vance also opened up shops. Highland Capital Management finalized its acquisition of ING Capital Management's European loan business and Babson Capital Management increased its presence following the acquisition of Duke Street Capital Debt Management.
But there has been a slowdown in new buyouts and private equity groups needed to find additional ways to get returns. "Recaps have been increasingly popular, though not by choice, but by necessity," said Herman Guelovani, a portfolio manager at NIB Capital Bank. "What happened in the last couple of years, especially in the last half of 2004 first half of 2005 was that there were very few companies up for sale: there was a slowdown in M&A and a slowdown in divestment in Europe." As a result, he said that private equity houses had few targets for their new funds but still needed to provide returns to investors. "Consequently, there were very few fresh transactions. Instead we saw a number of secondary, tertiary and even quaternary buyouts and, at the same time, an increasing number of recapitalizations, the latter being a source of dividend to private equity houses," he said.
For Fitch's study, the ratings agency looked at 38 deals that were refinanced by dividend recaps and shareholder loan repayments and 28 deals that underwent a sale to another sponsor in a secondary or tertiary buyout. In 2004 there were 12 deals that were done for a dividend recap and 26 in 2005. For the recycled buyouts there were seven done in 2004 and 21 done in 2005. Fitch Ratings says that of the 38 recaps for the purpose of dividends and shareholder loan repayments rated by the agency, sponsors have returned on average 72% of their original invested funds, about E7.1 billion. Some of the rapid quick deals that returned to the market include, Sigmakalon which came back in July 2005, just 10-months after its previous transaction, and Gala, first recycled in February 2005 and then again in September 2005.
With so many recycled deals being done, some have questioned how much leverage these companies can handle and will it ever get to the point where they can't. "That is the million pound or dollar question," said Mazzini. "When these companies are structured as LBOs, sponsors are looking primarily to improve operating performance via cost cutting and cash flows, meaning effectively running the company for cash to service the debt burden and minimize refinancing risk towards the end of the deal." Average leverage for the 66 recaps and recycled LBOs that are rated increased to 4.4 times from 3.6 times in 2004 and for senior debt to 5.5 times from 4.5 times in 2004, according to Fitch.
Another European investor said that eventually the market will get to the point where there is too much leverage and people will have to stop buying because they are losing too much money. "When you lose money, then you stop taking as many risks," he said. "But until that happens, I think people will continue to take that risk."
