Hitting a wall

To many market practitioners, private equity investment is something of a black art. From the point of view of the equity providers in particular, the distinction between a good deal and a bad deal is often thought of as a fine line. Joining a transaction as a participant in the senior debt facilities on the other hand is widely regarded much more straightforward, and less accident-prone.

Most GPs would agree with this view, but occasionally, just occasionally, a transaction comes along that tests this thesis in that it is the debt providers that experience the headache. A recent example was Montagu Private Equity's £860m acquisition of packaging group Linpac in August this year.

The market baulked
Initially, lining up debt funding for the deal went well. Sole mandated lead arranger Deutsche Bank achieved a 100 per cent hit rate in the sub-underwriting phase of the £713m equivalent total debt syndication, bringing in experienced LBO banks ABN Amro, HSBC, Lloyds TSB and Mizuho Corporate Bank.

Yet, to Deutsche's – and Montagu's – bemusement, when general syndication was launched in September, despite some forthcoming commitments, the wider market baulked and the bank decided to postpone the process.

The debt didn't sell even though Linpac was actually performing above the projections presented in the information memorandum. (Sponsor Montagu says the business will “deliver at least on plan this year”.) Furthermore, after the completion accounts had been prepared, the debt drawn initially was described as “significantly” below what had been projected in the documentation.

“This is a classic case of the herd mentality that can exist in the market,” commented Deutsche Bank. So what went wrong? One issue that caused many institutions to remain on the sidelines was the level of postbuyout investment that Linpac's management projected.

However, the more crucial aspect hampering the deal was one that can affect all major syndications: a lack of effective communication and understanding of the transaction story.

Here is why: One of the benchmarks used by the debt market in assessing a transaction is the level of leverage, as indicated by the ubiquitous debt to EBITDA ratio. Yet if EBITDA, which is a profit measure, is to be used as a proxy for cash flow, this ratio exhibits a fundamental weakness in that capital expenditure is not taken into account. This is especially important in a capital-intensive sector such as the packaging industry.

Too comfortable?
A simple adjustment can, of course, be made by considering debt / EBIT instead (which used to be standard practice in earlier days in the UK) or debt / EBITDA – Capex. However, in the case of the Linpac transaction, opening debt / EBITDA levels were already “just short of 6x” in the words of one invitee. Factoring in the capital expenditure forecast meant, according to the same potential investor, that “absolute leverage levels were a bridge too far.” So why were the arranging banks so comfortable with the proposition in the first place?

Part of the answer is a fact of life that participants in the senior debt syndication process are acutely aware of: the more junior one's position in the selling process, the less time one has to understand the business being acquired, which makes it more difficult to ascertain the risk profile of the credit in question.

Naturally the lead arranger doesn't have this problem. In the case of Linpac, Deutsche Bank would have been in direct contact with both the sponsor and the company's management for a comparatively long period of time, during which the debt structure for the transaction evolved. As part of its due diligence, Deutsche will have developed that all-important “feeling” for how the business was actually being run: an understanding in other words of the way management worked and, importantly, how this translated into the figures they presented.

The wider arranging group also had something of this advantage. Crucially, ABN Amro, HSBC and Lloyds TSB all knew Linpac already, while Mizuho had worked with Montagu on a number of occasions. All were therefore able to develop a deeper level of understanding of the business and its dynamics.

However, none of those invited in the wider distribution process were ever going to get equally close to the business. This wouldn't have mattered had the investment proposition been a more straightforward one. But the deal was complex, an aspect that a lead arranger can sometimes easily lose sight of.

Scepticism
According to Deutsche Bank, Linpac's forecast capital investment levels are well above what is likely actually to be spent. At present, it says, not only are profits above plan, but investment levels are below it. As a result, cash flow is predicted to be substantially ahead of forecast.

But participants in general syndication, often dismissed by underwriters as ‘stuffees’, can be forgiven for not accepting such representations at face value – especially in the packaging sector, which is notorious for its cyclicality. Other “benchmark” credits such as Smurfit and Kappa Packaging are widely cited by market insiders as currently performing below expectations.

Given these considerations, what is the credit committee of a bank looking at a credit like Linpac going to do? They will assume that profits will come in below those forecast. They will also assume that all the projected investment will be spent – after all, management wouldn't put forward such figures unless they aimed to spend it, would they?

Capital expenditure is one of the few items more or less directly in the control of management, so this seems reasonable, doesn't it? Seen in this light, turning down the proposition may well seem a pretty logical, and easily reached, conclusion.

And even if the numbers looked entirely reasonable, there is still that fundamental rule of banking: ‘Know thy customer’. In the busy world of leveraged finance, this can be a luxury that especially mere participants in a syndication don't have, prompting them to adopt a better-safe-than-sorry attitude and pass on a perfectly good opportunity. Needless to say that for a leveraged business, its equity sponsor and its debt arrangers, none of this is good news.

So what next for Linpac? Deutsche Bank aims to re-launch the transaction prior to the seasonal shutdown at the end of the year. Next time round, as the law of the market dictates, the proposition will have to be substantially better; otherwise the transaction is in danger of sinking without trace. Insiders report that the accountants are already at the company, preparing an analysis of performance and those all-important capital expenditure figures. Watch out for some structural tinkering too, just to make sure. Over to Linpac, Montagu and Deutsche Bank.