Deal terms tighten as pipeline grows
The pipeline of leveraged deals prepared for launch in the first part of 2004 is extensive, and banks and funds are eager to get assets on their balance sheets. While this is promising for the market, bankers are worried that structures are becoming too aggressive and some deals may struggle as a result. Taron Wade reports.
The first large deal off the blocks in 2004 was the leveraged buy-out of German chemical distributor Brenntag, which bookrunners launched on both sides of the Atlantic, securing a rating and pushing the equity contribution - at 25% - to what bankers believe is one of the lowest levels ever for a European LBO.
In an otherwise quiet January, as banks nurtured a growing crop of leveraged transactions, the deal triggered discussions among bankers over syndication strategy and whether structures on transactions were becoming too aggressive.
"Banks are really tapping the US market, we saw it on Inmarsat, Buhrmann and now with Brenntag - and this is mainly because of market conditions," says Debra Anderson, director at Intermediate Capital Managers Ltd (ICML), the asset management arm of Intermediate Capital Group (ICG).
In the US market, since nearly all leveraged buy-outs are publicly rated, pricing varies according to credit rating. Supply and demand also drive pricing changes, unlike in Europe where margins are generally static and it is structure that changes based on market dynamics.
The price differential between Europe and the US has inverted recently, meaning US deals pay relatively less than transactions in Europe. Because the deals pay more and institutional investors in the US are flush with cash, they are ready to look at any European company that owns US assets.
"What you find in general is that the balance of supply and demand in the European market is compensated to a degree by the in and outflows of the US market," says Nathalie Savey, head of leveraged loans at Axa Investment Managers. "Eighteen months ago, spreads in the US were 400bp-450bp and that was a good opportunity to invest in deals there."
Bankers believe that more leveraged deals will be syndicated in both Europe and North America as long as liquidity remains strong, although they will be limited to large transactions and businesses with US cashflows.
"Business generally is becoming more international," says a banker at a firm that takes sub-underwriting pieces in large LBOs. "The size of equity funds is increasing and they are looking at both sides of the Atlantic. As the average deal size increases they are no longer sticking to doing medium sized buy-outs in a particular jurisdiction and target companies are going to be more internationally based, with dollar and euro cashflows."
"There are an increasing number of deals we are thinking of using US institutional placement for," says Kristian Orssten, co-head of loan capital markets at JP Morgan in London. "But we need to look at deals on a case-by-case basis and keep in mind that the US market is very dynamic - pricing and liquidity can change overnight."
Indeed, in January, ABN Amro rearranged its loan distribution team to make it more global because of increased US investor interest in the European loan market. It appointed Ed Brown in a new role as global head of loan markets distribution, with teams in the US and Asia both reporting to him.
This increasingly global environment could exert some pressure on private equity houses to have more of their deals rated. If a transaction is going to be sold into the US, it needs to be classified by one of the three agencies.
And if the high yield market comes back in Europe - which looks likely, judging by the volumes of issuance already seen this year - that will also require companies to get rated in order to sell the bonds.
This in turn could cause deals to be priced more by credit risk. "The current market practice of pricing LBOs regardless of rating is somewhat counter-intuitive," says Chris Baines, head of European loan distribution for SG in London. "It may change as public ratings become more prevalent, particularly where a high yield or placement to the US institutional investor market is required."
Lessons of the past
Brenntag highlighted the changing deal structure in the European market, where transactions have become more highly geared. For the past few months bankers have warned that competition to lead deals has caused leverage to increase and documentation to become more relaxed.
"Some observers and practitioners believe the LBO market is showing signs of overheating," says Paul McKenna, head of leveraged syndicated finance at ING in London. "A perception exists that on a number of current transactions, leverage, average lives and equity contributions are being stretched, almost regardless of the quality of the underlying business.
"There are others, however, who point out that the stretching of lending criteria may well be justified by historically low interest rates, an improving macroeconomic and geopolitical landscape and swathes of investor liquidity - and time will tell who is right. But certainly the old adage 'back businesses, not structures' has a particular resonance at the moment."
"We shouldn't forget the lessons of the past - the telecoms were all over-levered," says Peter Cannon, fund manager responsible for collateralised debt obligations at RMF Investment Management in London. "We are spending a lot of time looking carefully at cashflows."
At the beginning of March, Fitch Ratings issued a warning that some first time leveraged buy-outs were being structured too aggressively. It said credit problems were likely to ensue if cashflows came under pressure over the next 18 months to two years.
But with purchase multiples lower than in the past, some deals justify lower equity percentages. And leverage does depend on the type of company and its ability to generate cash.
"If you look at the statistics for 2003, leverage multiples are flat on 2002," says Vijay Rajguru, director in leveraged loans at Barclays in London. "It's not the headline numbers that are more aggressive, but the flexibility being conceded by investors in elements of the structure and covenanting in certain deals."
For example, some deals allow sponsors to take out dividends and some have provisions that allow the senior debt to survive an initial public offering.
Typically when a company goes through an IPO, all the senior debt is repaid, but with these new conditions, proceeds are used to repay just enough debt to bring the company up to investment grade status.
Banks are also permitting headroom on covenants and allowing companies more leeway with capital expenditure and acquisitions.
Another new development in the structure of leveraged transactions is the appearance of a second lien tranche, which is subordinated to the senior debt, yet higher in the capital structure than the equity.
In the £2.7bn capital increase for Invensys there is a £267m five year and nine month second lien tranche. And in the debt supporting the buy-out of Brenntag there is a Eu60m 9.5 year subordinated tranche that was sold in the US.
Mandated lead arrangers for Brenntag - Citigroup, Dresdner Kleinwort Wasserstein, Goldman Sachs and SG - have said the second lien was put in to help senior lenders get more comfortable with the low equity percentage.
But one London based leveraged professional says second lien debt only works at the moment because of specific demand from the US, where there has been a shortage of high yield issues.
Taking the pain
Competitive pressures continue to affect all aspects of the leveraged loan market. Fees for arrangers are dropping but since banks still want to see deals syndicated successfully, they are taking the hit.
"The predominant mood of the market continues to be fear," says Greg Lomas, head of loan underwriting and distribution at CIBC in London. "An arranger doesn't want to be stuck with a deal that they can't syndicate so they will continue to take the pain."
Morgan Stanley has turned up the heat, making some high profile hires over the past two months to beef up its leveraged finance business.
The bank brought in Oliver Duff from Goldman Sachs in February to head its leveraged finance loan team. And shortly before that, Simon Parry-Wingfield also jumped from Goldman to Morgan Stanley's leveraged finance division. Thomas Deininger from Bear Stearns, who will be trading leveraged and distressed loans, is the newest member of the team.
Although it has not made any recent visible hires, Dresdner Kleinwort Wasserstein has been focusing more resources on leveraged finance. About two years ago, the bank's self-contained high yield and leveraged unit, which was not integrated with the advisory group, was replaced with a new, integrated group to increase focus on larger sponsors.
Spence Clunie, co-head of European leveraged finance in London, who was brought in at that time, says the sponsor coverage group has increased substantially since the arrival of Pascal Maeter from JP Morgan as head of the financial sponsors group late last year. Maeter has hired five people for the London-based group since he joined the firm.
"Previously, we didn't speak to the US-based venture capital firms, but now we do, and we still speak to the mid-market players as well," Clunie says.
The leveraged finance group, which has increased its dealflow, is split between London and Frankfurt with Joachim Koolman, as co-head with Clunie, located in Frankfurt.
Slowly but surely
Institutional investors still make up a small percentage of asset takers on LBOs in the European market. But they continue to launch new funds - all the major managers are raising new funds in 2004 and remain hungry for assets.
"The fundraising landscape for CDOs is better, which means we will see some incremental liquidity," says Richard Howell, head of leveraged capital markets at Lehman Brothers in London.
Banks now make up about 70% of the market, whereas a year ago most professionals in the market would have quoted a figure of 80%. This is mostly because investors are raising new funds, however, and not because of new entrants in the market.
But recently hedge funds have started to play in leveraged loans, though this has been mostly through the secondary market.
"The reality is they are value seekers looking for situations where they can take advantage," says a banker. "They are not going to be putting up much in primary, but they are probably useful in the growing up of our market - I see it as a positive."
It is not just European hedge funds looking at the European loan market, it is US hedge funds as well. And with leveraged cable deals hitting the market, such as NTL and Cablecom, hedge funds may look at participating in those deals on the primary side.
"There is a lot of debt out there and there is a finite capacity for cable assets amongst banks in Europe," says ICML's Anderson. She adds that these deals have the potential to syndicate well. "These cable companies have a maturing corporate profile and they've gone through balance sheet restructurings and should be coming back to market with more reasonable leverage levels."
Institutions flex their muscles
A new feature of the institutional market is an emerging tiering of players. The larger, more prominent investors are now able to take larger tickets of deals, usually in the Eu30m-Eu50m range, and are being shown deals first.
This is the first step towards the funds gaining greater influence in the market.
"Over time, structures will adapt and more directly accommodate institutional demand for European leveraged loan assets," says Barclays' Rajguru.
Some say, however, that this will only happen when institutions are regularly buying over half of any leveraged deal.
In a good fundraising environment, banks are also getting interested in CLOs. Mizuho is raising funding for its first CLO and there are rumours in the market that other banks are mulling the idea as well.
Duke Street Capital, however, is examining the possibility of selling its debt investment business. This news has generated a lot of speculation among CLO investors as to why they are getting out of the business and who might buy it. In 2002 Barclays divested its CDO business, which was purchased by Alchemy Partners and renamed Alcentra.
US investors might consider buying it, since many are looking to get into the European leveraged loan market.
"If a US investor bought it that would be good as it would bring more liquidity into the market and demonstrate confidence in the asset class," says a leveraged loan syndicator in London.
Mezzanine loans are in strong demand as new funds keep appearing and investors are able to take larger tickets.
Bankers predict there will be some of the same differentiation between investors in this asset class as in senior loans.
"For investors sourcing mezzanine there will be differentiating factors - your relationship with the debt and equity providers, your track record in managing mezzanine and the amount of capital you can commit to each deal," says David Forbes-Nixon, chief investment officer and head of European operations at the Alcentra Group.
"This year it could potentially be even harder for investors to source mezzanine," says Matthew Previte, executive director in leveraged finance syndications at WestLB in London. "It seems as though everyone is taking pieces - CDOs, banks and specialists."
As they increase in numbers and can hold more and more debt, investors in mezzanine are starting to talk to sponsors about getting more call protection.
Private equity houses see the minimal call protection on mezzanine debt as one of its main advantages over high yield subordinated bonds and it will be interesting to see if they view this as a realistic request. Typically the call protection mezzanine investors get is 103% of par in the first year, 102% of par in the second and 101% in the third year.
"We should have some protection on the mezzanine, particularly on a recap, because we are giving the equity a return and the next likely event is an exit," says Nick Petrusic, director at GSC Partners.
Forbes-Nixon agrees that it would be nice to see more protection. "The best names refinance early," he says.
Greater call protection would be more difficult to achieve in a traditional first time buy-out, however.
Exploring new territories
WIth demand for mezzanine particularly hot at the moment, mezzanine specialist funds have continued to look for fresh opportunities outside their traditional stamping grounds.
ICG announced in February that it is opening an office in Madrid to capitalise on the growing leveraged buy-out market there. Although it has been doing deals in southern Europe for a while, ICG expects the Spanish market to double in the next three years and believes having a permanent presence on the ground will give it a competitive advantage.
Separately, Mezzanine Management launched a fund to focus on eastern Europe last year and in February announced its second investment in the region. It provided a mix of equity and mezzanine to Lux-Med, a private healthcare company in Poland.
The fund's first investment was made early in 2003, in which the new fund, called Accession Capital Management, provided funding for the buy-out of the Hungarian national commercial radio station Danubius Radio, with equity from Advent International.