Financing Europe's LBO boom
Leveraged buy-outs (LBOs) have become one of the hottest areas of European investment banking, fuelled by the availability of increasingly varied and cost effective forms of financing. Banks have been rushing to put acquisition finance teams in place, attracted by the high returns on offer. Institutional investors, particularly from the US, are creating a new capital pool for senior debt financing. High yield bonds are starting to take off in Europe. Mezzanine is still plentiful. And the supply of private equity and venture capital is at an all-time high. Some financiers already fear that the LBO market may be overheating. At a time when asset prices are so high, and the competition for deals so intense, they believe that the market risks a repetition of its collapse in the early 1990s unless the currently hectic pace of activity slows down. But others say things are different this time -- that the economic outlook in Europe is much better than in the late 1980s; that lenders and investors are much more selective about the deals they will do, and how they structure them; that the development of new and more sophisticated forms of financing has fundamentally changed the dynamics of the LBO market; and that the long term prospects are bright. It is too early to tell who is right. But, one way or another, it is going to be an exciting ride in the leveraged finance market. Charles Olivier reports.
Last year, an estimated £22bn ($36bn) of leveraged buy-outs (LBOs) were completed in the UK and continental Europe -- 40% more than in 1996 and 140% more than in 1995.
Compared to the mid-1990s (when it was rare to see a European LBO larger than $200m) the size of some of the deals being done today is astonishing. In the fourth quarter of 1997, there were no fewer than seven buy-outs over $750m in size.
Last year, a group of venture capitalists paid Lit3,100bn ($1.7bn) for SEAT, an Italian publisher of trade directories. Although this is not on a par with deals like the $25bn buy-out of RJR Nabisco in the heyday of the late 1980s US LBO market, these are large transactions for a sector that was dead in the water five years ago.
The range of companies being bought by financial buyers has expanded too. Gone are the days when the only firms bought by LBOs funds were ponderous UK engineering companies with management problems. Today, they are buying bingo clubs (Gala Bingo), mail order shopping companies (Betterware) and bookmakers (William Hill).
And not just in the UK either. According to the Nottingham-based Centre for Management Buy-Out Research, over $10.1bn worth of buy-outs were completed in continental Europe in 1996 (the last year for which authoritative data is available).
The figure for 1997 is much higher at an estimated $19.6bn -- more, for the first time ever, than the UK market. The busiest markets by some margin have been Germany and France. But Scandinavia, Italy and Spain have all seen significant increases in deal flows, while activity in the Netherlands is also picking up.
Part of the reason for this is that continental vendors are finally sloughing off their antipathy towards financial buyers. Historically, most of the companies being bought by LBOs funds were family owned firms.
Now major industrial companies in Europe are welcoming LBO funds as bidders for unwanted businesses, aware that the growing availability of low cost debt is enabling financial buyers to outbid trade buyers with increasing regularity.
Just last week, the Dutch packaging and distribution group KNP agreed a Dfl 3.4bn ($1.6bn) sale of its packaging division to UK venture capitalists CVC and Cinven in the largest LBO in Europe this year.
The successful bid is highly leveraged. Around 80% of the financing package, arranged by Barclays Capital, is in the form of debt -- including a syndicated loan and a high yield bond issue that could be the largest yet in European currency.
The KNP deal symbolises the dynamics driving the LBO boom. The CVC/Cinven joint bid outstripped rival financial buyers Investcorp and Candover, as well as trade buyers including UK packaging company David S Smith and Finnish pulp and paper group Metsa-Serla.
And the financing package put together for the deal enabled the winning bidders to pay a price that was described by one sector analyst as "very steep".
Today, it is rare to find a European disposal auction that does not include at least two LBO funds, and players like UK-based investment firm Doughty Hanson have become widely respected.
As LBO deal volumes have risen (and margins on traditional areas of business like corporate loans fallen), banks have piled into the European leveraged finance business with a gusto not seen since the late 1980s.
All the US bulge-bracket firms, having dropped out of the market in the early 1990s, are back in the syndicated loan market -- many with senior bankers from New York at the helm -- and are enthusiastically pushing capabilities such as leveraged lending, securitisation and high yield bonds.
Meanwhile, European investment banks are hiring acquisition finance staff at a rapid rate, and experienced leveraged financiers have become as hard to find as World Cup tickets.
"Acquisition and leveraged buy-out financing is one of the hot areas of investment banking," says Iain McCarthy, a director at Bankers Trust in London, one of the leading firms in the acquisition finance market for the past few years.
With so many lenders trying to make their name in the market, venture capitalists have been able to demand (and get) extremely large amounts of long dated, low cost senior debt -- thereby increasing hugely the range of deals they are able to do.
"When we did Thorn Lighting in 1993, we could not get anyone to underwrite a £100m deal," remembers Johannes Huth, director of Investcorp -- the Bahrain-based investment firm that has led a number of highly successful buy-outs and acquisitions in Europe. "Banks were prepared to do £25m, maybe £50m but that was it. Today, you can find any number of banks willing to underwrite $1bn+ deals."
Perhaps the biggest driver of growth in the European buy-out market has been the spectacular increase in the number of European LBO funds over the last four years. In the early 1990s, the number of venture capitalists looking seriously at LBOs was little more than a handful: Cinven, Charterhouse, CVC, Electra, NatWest, 3i, Candover, Investcorp and Schroder Ventures. Today, the European Venture Capital Association (EVCA) estimates that there are more than 500 venture capital companies in Europe of which around 200 are actively involved in leveraged buy-outs.
And just as the number of equity providers has risen, so too has the amount of money they have to play with. According to the EVCA, the amount of money controlled by European venture capital funds has rocketed from around $40bn in 1992 to an estimated $100bn at the end of 1997.
Over $65bn of new capital has been raised since 1996 alone -- with several players such as Schroders, Charterhouse, Candover and BC Partners setting up $1bn funds. Last year, Doughty Hanson, one of the most prolific venture capital firms in Europe, raised a $2.5bn buy-out fund.
Despite high asset prices and some signs of over heating in the first quarter of 1998, bankers and venture capitalists believe that the European LBO market could get even busier this year.
"Enquiry levels in the first quarter of 1998 have been as least as high as they were last year, maybe even higher," says McCarthy at Bankers Trust.
Bankers such as Alan Jones, managing director and head of European acquisition finance at Morgan Stanley Dean Witter, believe that annual LBO volumes in Europe could go as high as $25bn, driven by the wide availability of equity finance. "One of the factors driving the growth in the market is the substantial amount of private equity available for investment," says Jones. "There's easily $15bn to $20bn of private equity dedicated to European buy-outs.
"If the sponsors leverage that four times, they have the capacity to do $60bn to $80bn of acquisitions. Since the sponsors will want to invest these funds over a two to three year period, the potential exists -- in theory at least -- for up to $20bn-$25bn of European LBOs a year."
According to Jones, the next stage will be growth in public-to-private transactions through the buy-out of publicly quoted companies. "I think we will see many more public to private deals being done in Europe," he says. "There is a large number of high quality companies whose shares have underperformed the overall market for technical rather than fundamental reasons."
Explains Jones: "Many solid, middle-market companies simply don't have enough of a public float either to attract broad research coverage or to provide institutional investors with a sufficiently liquid trading market. This inefficiency creates terrific opportunities for private equity investors."
In addition, he does not rule out the use of LBO style recapitalisations -- or going-private transactions -- as a defence mechanism against hostile threats, either real or perceived. LBO funds, for their part, are more likely to act as white knights than as hostile bidders.
Inevitably, with so much equity capital chasing a limited number of deals, venture capitalists and other acquirers have had to take risks to stay in the game over the past 12 months.
Price to earnings multiples (the traditional method of calculating the relative value of acquisitions) have risen from five or six times in the mid-1990s to eight or nine times and often higher. Late last year, Cinven paid £860m for IPC, a UK consumer magazine publishing group with historical earnings of just £63m. Even if 1997 earnings turn out to be much higher, say £80m, this still leaves Cinven paying a price to EBITDA ratio of 10.5.
Lenders, who cannot afford to turn down deals having invested so much money building up their acquisition financing departments, have had little choice but to take greater risks too. They are allowing, for example, far higher levels of leverage on senior debt financing than they did in the mid-1990s.
In 1994 when Glenisla, the European arm of US buy-out giant KKR, bought Reed Regional Newspapers, it was regarded as very aggressive for Reed to have a debt to EBIT (earnings before interest and tax) ratio of 5.5. Today such a deal would be considered conservative. Many deals such as William Hill and IPC have debt to EBIT ratios of seven or more.
Curiously, debt to equity ratios (ie the percentage of total financing provided by the two sources of capital) have not moved nearly as far. There are few deals where equity accounts for 50% of the total cost of an acquisition, as was the case for deals like the LBO of Gardner Merchant, the Anglo/French catering company in 1993, but it is still very rare to see equity contributions fall below 20%.
The average maturity of LBO debt financings has got much longer -- as has the date at which companies begin to pay back the principal. In the early 1990s, the average maturity for an LBO senior debt financing was five years.
Some lenders were prepared on occasion to go out to seven years, but insisted on heavy interest and principal payments in years one and two. Today, most LBOs are financed with a mixture of seven, eight and nine year debt with some deals going out even further.
In 1997, Investcorp financed the acquisition of Welcome Break, a UK chain of motorway service stations, with £321m of debt at maturities of 10. 13, 18 and 20 years.
Even though LBOs have become more leveraged, the margin paid to debt providers has fallen over the last five years.
Spreads on seven year senior debt, for example, have declined from 225bp over Libor in the mid-1990s to 175bp over Libor today. Fees have remained relatively stable at around 2% to 2.5% of the total issue size, although some deals are rumoured to have been done for less than 1.5%.
So desperate have lenders become to establish themselves as leading providers of LBO finance, that it has become commonplace for banks to agree to underwrite high yield bond issues.
According to market rumour, Deutsche Morgan Grenfell, which has been one of the most ambitious new entrants to the European LBO market, recently agreed to fully underwrite a $250m bond issue for SEAT, the Italian yellow pages company.
The most startling changes have taken place on covenant requirements. Pre-payment penalties, long the mainstay of senior debt lenders, are increasingly rare. Interest cover ratio requirements, meanwhile, have fallen from 2.5% to less than 1.5%.
But are venture capitalists and lenders going too far? Some market veterans warn that LBO players could be in danger of repeating the mistakes they made in the late 1980s. Then several highly-leveraged LBOs such as Isosceles, the buy-out of Gateway supermarkets, and Magnet went bankrupt after taking on too much debt just before the UK economy went into recession.
Ken Robbie, director of the Centre for Management Buy-Out Research, is concerned about this. "There is an obvious danger with the prices being paid at the moment," he says.
"Debt levels are not as high as they were in the 1980s but they are getting close. And if the UK economy does go into recession, a lot of the deals being done now may run into trouble."
Robbie is far from being a lone voice. "I wouldn't be surprised to see banks struggling to get their money back on some of the 1997 deals, especially if the economic climate deteriorates," warns Duncan Aldred, director of Charterhouse Development Capital. "Have people forgotten what happened in the late 1980s?"
Publicly, however, most bankers and venture capitalists remain optimistic that the market is not heading for a 1980s-style crash. Many such as Julian van Kan, head of acquisition finance at Banque Nationale de Paris, argue that the quality of deals being done today is much higher than in the late 1980s.
"There is the same kind of excitement around," he says. "But equity providers and lenders are being much more selective. Many of the deals which were done in the 1980s just would not get done today."
Others like McCarthy at Bankers Trust point out that although leverage levels have risen, the total amount of debt being taken on by LBOs today is much lower than it was in the 1980s. "You don't see many equity providers pushing for 90:10 debt to equity ratios these days," he says. "The benchmark is 20%."
At the same time, Norman Murray, chairman of Deutsche Morgan Grenfell Asset Management, says the chances of the UK or continental Europe falling into a deep recession are remote. "If we went into a sudden recession I think a lot of the deals being done now would default," says Murray. "But the key point is that a deep recession is unlikely. The economic outlook is much better than it was in the late 1980s."
Perhaps the biggest difference between the two booms is the way in which the LBOs are financed. In the 1980s, there was only one way to finance an LBO -- senior debt, mezzanine finance and equity.
Today, venture capitalists can draw on a huge number of financing options including high yield bonds, securitisation and 'B' and 'C' note loan tranches -- typically eight and nine year bullet loans placed with US institutional investors such as life insurance companies.
"Financing structures are far more sophisticated than they were a few years ago," says Don McCree, managing director and head of syndicated finance at Chase Manhattan in London.
These new forms of financing offer three key advantages over the old senior/mezzanine/equity structure. First, they allow borrowers to take on large amounts of debt without having to rely on major lending banks.
Second, they permit venture capitalists to spread debt repayments on LBOs over a much longer time. Third, they reduce the total cost of debt financing -- thereby allowing LBO funds to maintain return on equity targets on highly priced deals.
In theory at least, this should make many of the recent LBOs much less vulnerable than those completed in the 1980s. If one compares the debt repayment schedules of Isosceles, which had to pay £147m in its first year, with that of Welcome Break (£25m), most LBOs done over the past four years are more sensibly structured than those done in the mid-1980s. This makes them less likely to run into trouble.
But despite the enthusiasm for new forms of financing such as high yield bonds, and widespread confidence that a 1980s style recession is unlikely, the future direction of the European LBO market remains uncertain. First and foremost, nobody is sure whether the current frenetic level of activity can be maintained this year. Certainly, the number of companies up for sale is likely to remain high as the consolidation and restructuring of Europe Inc continues.
But many venture capitalists are concerned that asset prices are too high to permit LBOs to be executed successfully.
"Prices are too high," says Aldred at Charterhouse Development Capital. "In 1991 we bought a growing, international, market-leading company called Devro for 5.5 times EBIT.
"I know times have moved on and interest rates are now lower but when you see equity houses today regularly buying pretty average businesses for 12 times EBIT, it's fair to say that prices are too high."
Whether venture capitalists will withdraw from the market as a result of such fears remains to be seen. Publicly, most insist that they are as active as ever. But one or two admit that they are more cautious about making leveraged buy-outs than they were in 1997.
"Asset prices are looking quite high," says Robert Clarke, director of Electra Fleming. "We have not made any acquisitions so far this year and are being very selective. I would be wary about buying a UK cyclical company in the current market."
Second, bank appetite for highly leveraged senior debt transactions is waning. For most of 1997, there seemed no limit on the amount of debt that venture capitalists could raise in the syndicated loan market. The result of this was that almost any deal, no matter how leveraged, could find the debt financing it needed. But in the last two months, one or two deals have run into trouble -- notably HMV Media.
When SBC Warburg Dillon Read and Merrill Lynch launched the first financing package for the HMV buy-out in March 1998, the structure of the deal was as follows -- £375m of senior 'A' and 'B' debt (comprising a £175m six year 'A' loan, a £100m six year revolver and £100m of seven year 'B' notes), £75m of eight year 'C' notes, £50m of eight year 'D' notes and £186m of equity provided by EMI and Advent. One month later, after struggling to find banks willing to participate in the syndicated loan elements of the deal, the two arrangers were forced to change the financing structure.
The total amount of 'A' and 'B' note debt which was targeted at banks was reduced from £375m to £325m. Meanwhile the 'C' and 'D' note debt to be sold to institutional investors was increased from £125m to £135m.
At the same time, equity financing was increased from £187m to £237m. The ticket sizes for syndicate banks were reduced too -- from £60m and £40m respectively to £50m and £30m -- with no change in the margins being paid of 200bp and 225bp respectively.
Whether the difficulties encountered on financing acquisition deals like HMV Media and William Hill in the loan market are a sign of future troubles to come is debatable. The highly successful recent syndication of Chase Manhattan's DM225m loan backing the buy-out of Derby Cycle Corp by Thayer Capital and Perseus Capital indicates that there is still plenty of demand among lenders for deals that are correctly priced and structured.
The seven year revolving credit, which carries a margin of 200bp over Libor, attracted more than DM300m in syndication.
Despite this, some bankers are apprehensive. "The market has definitely turned," says one leading acquisition financier. "Many banks believe the envelope has been pushed too far on some recent deals in terms of leverage and structure and are saying enough is enough."
According to market rumour, several banks are sitting on large amounts of paper that they cannot syndicate. This may not be a problem for now. But, as the paper builds up, credit committees will question and may even prevent acquisition finance departments from bidding for future deals until the backlog has been cleared.
However, others like McCarthy at Bankers Trust are less pessimistic. They argue that the problems of the early months of 1998 were the result of unexpectedly high deal volumes rather than decreased appetite on the part of bank lenders. "The first quarter of this year has been extraordinarily busy with up to 10 sizeable deals all coming to the market at once," he says. "The banks did not have the infrastructure or resources to cope with it."
This sentiment is echoed by another leading UK banker. "Most of the banks who participate in the syndicated loan market have only two or three people in their acquisition finance departments," he says.
"This is not enough for them to look closely at more than one or two deals a time. So when eight or 10 come out at once, they have to turn quite a few deals down."
Bankers Trust's McCarthy believes that as the direction of the market becomes clearer, banks will hire more people to cope with the increased level of demand for LBO financing, thereby allowing deals to be syndicated properly.
But, he admits, this may not be easy. "There is a shortage of experienced acquisition financiers," he says. "It is a specialised business which requires a good knowledge of what has gone on before. You need people who can hit the ground running and there aren't many of those."
Nevertheless, assuming that deal flows do not continue at their frenetic rate, there seems no reason why debt financing should become so hard to find that LBOs cannot get done.
Leith Robertson, head of acquisition finance at the Royal Bank of Scotland and a veteran of the UK LBO market certainly thinks so. "I expect there to be sufficient capacity in the market," he says.
However, 1998 is likely to be a much more difficult year for debt providers than 1997. Even if banks do hire more people, it is still likely to remain hard for the next six months at least to syndicate highly-leveraged LBOs.
The number of banks willing to participate in LBO syndicated loans is still relatively small -- probably no more than 60 at most. In addition, few banks are willing to take on more than £15m on any deal where they are not the lead or, at least, co-arranger. Any arranger looking to syndicate a £300m senior debt package, therefore, needs to persuade at least 20 banks to participate if a deal is to be syndicated successfully. "You need to get a pretty high hit rate of the core banks to ensure the success of primary syndication," admits McCarthy.
This leaves the major LBO debt providers in a dilemma. They can either bid aggressively for arranger mandates and risk saddling themselves with large amounts of debt they cannot syndicate and which may, if recession hits, default. Or they can demand higher margins and risk losing business to rival firms.
The choices facing venture capitalists are none too simple either. They must either make no acquisitions at all and risk the anger of equity investors who want to see their money being put to work. Alternatively they have to pay high price to earnings multiples and risk losing large sums of money on deals that go wrong when economic growth slows and stockmarket valuations fall.
In all probability, lenders and venture capitalists will choose to keep on going in the hope that their successes outweigh their failures. "It is like crossing the road," says one London-based financier. "You know there is a risk that you might get run over. But if you never cross the road, you never get anywhere."
The key to success will lie, as it always has done, in the careful structuring of LBO financing packages.
This essentially comes down to three elements: reducing the cost of financing the debt as much as possible; structuring the repayment schedule to ensure that companies are not loaded down with interest payments in the early years after the LBO; and tailoring covenant requirements to ensure that investors are offered reasonable protection without preventing the company from making the strategic changes it needs to make the business grow.
However, good financing cannot prevent a bad deal from going wrong. Even if Magnet had been financed with high yield bonds instead of mezzanine, for example, it is hard to see how it would have avoided bankruptcy given the extraordinary fall in earnings it suffered in the early years after its acquisition.
Nevertheless, in the vast majority of cases, the success or failure of an LBO can be heavily influenced by the initial way in which an acquisition is financed. Had 'B' and 'C' loan notes been available at the time of the Isosceles deal (the LBO of Gateway supermarkets), for example, it is just possible that the company would have survived.
As some of the case studies included in this report show, the evolution of new forms of financing such as securitisation and high yield bonds has had a tremendous impact on the ability of venture capitalists to execute large, complex and often highly leveraged LBOs.
But if the LBO boom is to continue at its present rate these new financing techniques will have to evolve further. Asset prices are simply too high at present for senior debt providers to shoulder all the risk and none of the upside.
One key issue is the development of the high yield bond markets. At present, the number of European fund managers willing to buy LBO related high yield bonds is extremely limited.
As a result, the only LBOs that can use high yield bonds are those large enough and high profile enough to attract US investors (which continue to account for at least 80% of the total high yield investor universe).
If, as seems likely, senior lenders become more cautious about lending large sums of senior debt, the high yield bond market will have to expand quickly to take up the slack.
Similar problems exist with securitisation. Over the last four years, the number of assets that can be securitised has exploded. Nomura Principal Finance, in particular, has had tremendous success in persuading rating agencies to rate bonds backed by new forms of cashflow.
Nevertheless, in almost all cases, the companies concerned have had large property portfolios. For securitisation to become a major weapon in the LBO financier's armoury, banks and issuers need to persuade rating agencies to rate bonds backed by standard, non-property-related cashflows.
One recent development that has encouraged many LBO players has been the emergence of institutional investors prepared to buy senior debt -- particularly the 'B' and 'C' tranches.
But, like the high yield bond market, the number of investors looking at the European market remains very small. In the US, for example, there are over 200 institutions that can and do buy such paper. In Europe, there are less than five.
Given the low level of yields on standard fixed income instruments such as corporate bonds, it seems reasonable to expect each of these three market segments to grow significantly over the coming years. But it will not happen instantly. European fixed income investors are a cautious breed. They are unlikely to start buying these new forms of debt on a regular basis overnight.
Until they do, therefore, banks and venture capitalists will have to learn to become more inventive with the products they have already at their disposal. If they do not, deal flows could dry up.
So far, both have shown an encouraging willingness to be flexible. Most LBO funds have lowered their return on equity targets from 35% to 25%, for example. Meanwhile, lenders have abandoned many of the taboos that prevented deals from getting done in the early 1990s such as insisting on pre-payment penalties and excessively high levels of interest cover.
But who will make the concessions -- lenders or borrowers? On structure, few bankers see any room for further loosening. None are willing to lend at longer than nine years on unsecured debt. None will be happy to allow further erosion of covenant requirements. Most are keen to see spreads go up and fees increased.
Meanwhile, venture capitalists are likely to resist any attempt by banks to force them to put in more equity (thereby lowering the amount they can make on the deal). This battle between equity providers and lenders is far from new. But it is likely to become increasingly intense over the course of the coming year.
For all the short term uncertainties, however, the long term future of the European LBO market looks exciting. One or two deals will undoubtedly go wrong. They always do.
But provided none of them involve high yield bonds, there seems no reason why the leveraged buy-out cannot shrug off its slightly seedy reputation to become a regular feature of the European M&A landscape. EW