Gatecrashing the London club

Specialist credit funds have revolutionised the leveraged loan market. But could this mean trouble for the private equity industry when things start to go wrong? James Taylor and Andy Thomson report.

The rise and rise of specialist debt investors has been a major driving force behind the current private equity boom, but it could cause serious problems in the event of a downturn. That at least is the conclusion of a recent report by independent leveraged debt specialists Blenheim Advisors, which highlighted the growing influence of CLOs (collateralised loan obligations), dedicated vehicles that invest in debt markets.

The huge increase in the number of these funds and their subsequent demand for assets has created massive liquidity in the leveraged loan market, and thus allowed private equity sponsors to take on bigger and more daring transactions.

“These investors provide a lot of liquidity to the sponsor and to the leveraged finance market in general – and they're here to stay,” says Nathalie Faure Beaulieu, a managing director in the London office of European Capital, an integrated finance provider.

Blenheim managing director William Allen says, in many ways, this is no bad thing. “The new investors have created more sophistication in pricing risk,” he says. “We're seeing deals up to five times oversubscribed, which means you can re-price – thereby losing the oversubscription – but get better pricing. So there's a real benefit for the borrower: they can raise more debt and pay more for businesses.”

However, because many of these funds are primarily return-focused rather than relationship-driven, private equity sponsors could find themselves in trouble if portfolio companies go into default or are forced to restructure.

At the recent European Venture Capital Association investor conference in Geneva, many delegates expressed concern about the increasing levels of leverage currently being employed in buyout deals.

In previous years, before the explosion in the CLO market, banks would provide private equity firms with leveraged loans to finance buyout deals and then keep this debt on their balance sheet. Nowadays, the emergence of dedicated credit funds has allowed banks to parcel these loans up and syndicate them on, reducing their balance sheet risk.

One difficulty this creates is that it is much harder for sponsors to know where all the debt is, and to manage relationships with their investors. Blenheim is trying to obviate this by implementing a system that tracks every tranche of a syndicated loan, whenever it is sold on to a third party. This will theoretically make it easier for sponsors to manage their debtor base, although the firm accepts that not all funds will be willing to disclose full details of a sale – particularly the price paid.

However, Blenheim believes the major difficulty will come when a private equity-backed company goes into default on its loan covenants, or requires a restructuring of its debt. The sheer number of debtors will make this negotiation process complicated enough in practical terms, particularly since funds can trade in and out of positions from week-to-week. Indeed, most CLOs can only invest a certain proportion of their funds in distressed debt, so they are often forced to do so.

Because you can't be sure who you might end up dealing with when transfer rights are open, private equity firms often want consent rights which allow them to say, ‘we don't want you to pass on the debt to x, y or z’

Andrew Barker

But the key issue is that whereas before the debt was held by relationship-driven banks, in most cases it will now be held by return-driven credit funds – which are more likely to take an aggressive approach to the negotiation. Allen says the days of “The London Approach” – by reputation, a civilised process whereby sponsors would sit down with bankers and work out an amicable debt restructuring without relinquishing control of their companies – may be a thing of the past.

Allen says: “In today's market syndicates are heavily weighted towards institutional investors, a large majority of whom have taken loan positions on the basis of return rather than relationship and therefore we believe there will be a much more aggressive position taken by lenders in future restructurings.”

Signs of trouble in the European private equity market have already been witnessed. Towards the end of last year, Damovo, a Scottish telecom group acquired by Apax Partners for £245 million ($480 million) in 2001, agreed to hand over all its equity to bondholders after a restructuring enforced by Damovo's inability to pay its debts. At around the same time, Bahrain-based Investcorp saw a £250 million investment in UK printing group Polestar wiped out; while TMD Friction, a German brake manufacturer, completed a restructuring in which most of the equity owned by Montagu Private Equity was lost.

Simon Tilley, a director at Close Brothers Corporate Finance, says one way private equity firms can react to the new scenario is by seeking to get closer to the new investor base: “The forwardpage thinking will set their sights on relationships with the secondary debt traders and developing a better understanding of each other's business models,” he says. “If a company is in serious financial difficulty, nothing will stop a hedge fund or other debt provider from acting to protect its credit position. But a good relationship may mean a better outcome.”

While such a relationship may seem unlikely, Tilley points to mutual benefits. “They have different skill sets and it is likely that hedge funds and the like will look to the deep experience and track record that private equity investors have of managing an investment through its lifecycle, particularly in situations where there is a requirement for operational restructuring or other active investor management.”

Andrew Barker, an acquisition finance specialist at international law firm Jones Day, suggests another possible response in the form of an altogether more defensive tactic. He explains: “Because you can't be sure who you might end up dealing with when transfer rights are open, private equity firms often want consent rights which allow them to say, ‘we don't want you to pass on the debt to x, y or z’.” The targets of such a clause, say those who have seen them in operation, are often hedge funds.

The ability of a GP to win such consent rights may depend on how much credibility it has in the market place, or perhaps the extent to which it prepared to compromise in other areas of the credit agreement. But with the increasing potential for strangers in the debt structure to cause problems down the line, the ability to sell out of positions freely is, and will continue to be, a highly sensitive issue.