The leveraged buy-out market is well known to be cyclical. Interest in the market builds, usually in times of economic growth, and more and more money is sucked in to private equity funds and the debt that finances their deals.
Competition between funds for new acquisitions becomes intense, and rivalry between banks and investors to lend the funds money makes debt ever more cheaper and plentiful, fuelling the boom.
Then it bursts, showering egg on to many faces. Defaults rise, dealflow dries up and the talk is all about refinancing and restructuring. After a while the market bottoms out and the cycle begins again.
Now the market has entered a new dip — but this time, at the wrong point in the cycle. The LBO curve was just coming out of its bottom, with default rates still around 1% and leverage multiples still fairly moderate. The next bubble seemed a long way off.
But when no one expected it, the market screeched to a halt. Nothing has gone wrong in the world of private equity and leveraged finance itself. A few overgeared companies are struggling with their debts, as usual, but nothing to frighten the horses.
The problem is macroeconomic, and it is seeping into the LBO world from the ‘out’ end of the pipe — the high yield bond market.
Sovereign debt problems in Greece, Portugal, Italy — and even the US — have sent bond investors everywhere into risk-off mode. Credit spreads have whipsawed since June, and that means investors hate buying bonds.
Down to a trickle
Analysis by EuroWeek using Dealogic data last week showed that in the third quarter of 2011, only $4.8bn of high yield bonds were placed in Europe and $23bn in the US.
If that still sounds quite a lot, bear in mind that in the previous quarter, the numbers were $26bn and $91bn.
Is it a seasonal dip? No — in the third quarter of 2010, issuance was $16bn and $76bn, substantially higher than the quarter before.
Nor is this happening because private equity firms do not want to sell bonds. There is a big pipeline of 40-50 companies wanting to come to market in Europe alone. Of these mandates, an estimated €5bn are deals for companies, such as Coditel, Spie and Securitas Direct, that have been bought out with bridge loans from banks, which are now desperate to refinance the debt in the bond market.
When the European high yield market began to get choppy in June, this could be shrugged off as a bit of bad weather. But the high yield hiatus has now lasted for the best part of a quarter, and it has spread even to the much more vigorous US market. Fund managers have suffered outflows, and fear more.
The only new high yield issue in Europe since late July was on September 8 by Fresenius Medical Care, one of the best liked of the strong double-B credits that investors crave. There are few peers, and they are likely to avoid this troubled market if they can. More challenging deals, such as those for LBO companies, are off the cards.
This blockage is now serious, and its effects are being felt right back up the pipeline, by private equity funds. They are not in risk-off mode — they remain hungry to make acquisitions. But financing them has become much harder.
Not only is the bond market closed for now, but banks are reluctant to underwrite many new leveraged loans until they have cleared some of the backlog of risk.
Europe in denial?
So the flow of new LBOs has thinned, and is likely to dwindle more before it revives. In the US, there were only $10bn of new M&A deals by sponsor-backed companies in the third quarter — the lowest for six quarters. In Europe, the dealmakers still haven’t caught up with the dip — new M&A totalled $14bn, higher than in the first or second quarters.
Market participants are unanimous that this flow will fall in the fourth quarter. The question is, how bad will this dip get?
After the collapse of Lehman Brothers in September 2008, the high yield market for LBO companies was shut for 18 months, and the volume of new LBOs remained depressed throughout that period.
An LBO downturn of that magnitude remains unlikely. Compared with the dotcom bust and the Lehman crisis, the source of contagion this summer remains further away from the private equity market.
And it is worth pointing out that, if sentiment recovers, the European high yield market could snap back to its old form (or close to it) fairly quickly, as credit fundamentals remain solid and there is now a much broader base of dedicated high yield investors in Europe. If that happens in the next couple of months, some of the logjam could begin to be cleared. But for private equity LBOs, this is undoubtedly a second dip to the present crisis.
If the source of the problem is macroeconomic, so is the solution. Real progress on Europe’s sovereign debt problems would undoubtedly unblock the high yield pipeline and get the LBO engine revving again. But who would bet on when that will happen?