Leverage matters

Invite some of the most seasoned hands amongst the UK-based debt and mezzanine community to discuss how they see European leveraged finance at present and you might expect them to be resoundingly bullish. After all, deal flow has picked up, some very sizeable LBOs have been completed (think Seat Pagine Gialle, Debenhams and Fiat Avio) and the mid-market seems to be bubbling away nicely in the region's key countries. Business must be looking pretty good.

But no one likes to get it wrong in an LBO, as the fallout can be costly and time-consuming. Reputations are at risk as well. More particularly, no one wants to get it wrong in one of the major €1bn plus LBOs that have become increasingly common in Europe over the past few years because the numbers are very large – and the concomitant side effects are magnified.

This is one reason why Europe's leveraged finance providers are treading carefully as the markets across the region pick up momentum. And it is also a key reason why the financiers present at Private Equity International's European Leveraged Finance Roundtable held in London in mid-January – Richard Collins of Indigo Capital, Euan Hamilton of The Royal Bank of Scotland, John Leach of Barclays Capital, Stephen Mostyn-Williams of Cadwalader, Wickersham & Taft and Nick Petrusic of GSC Capital – are quick to map out what, in their books, it takes to get it right. What they share is the view that good and hence fundable deals are about finding the right companies, the right sponsors, the right structure and the right time.

“A few years ago you could raise debt for pretty much any business,” says RBS's Hamilton, “but now there is a far greater degree of polarisation between quality and nonquality. Banks are much more adept now at saying no to deals they deem as lower quality.” The nodding of heads around the table confirms this point and several also comment that whereas there used to be a tendency for banks to service what they regarded as lower quality deals with a lower multiple of debt (sub-three times debt multiple), today banks prefer to walk away. “Now banks are much more likely to say a flat ‘no thanks’ – even though the sponsors may well go somewhere else and find someone to take the deal,” says Hamilton.

This comment references another shift in the European leverage finance landscape: competition is now far more intense among banks and a number of institutions that used to happily sit lower down the food chain at the subsyndication level are now eager to win a seat at the top table. Barclays' Leach comments: “There's more supply than demand at present. Some continental banks now want to be in the top tier prompting them to bid very aggressively – a recent French recapitalisation opportunity attracted indicative debt multiples up to seven times.” Petrusic from GSC concurs: “I would say that the whole market is getting a bit frothy, we are starting to see some multiples being talked about that are, in my opinion, pushing things a little too far.”

Differing agendas?
It's at this stage that a discernible division begins to appear amongst the group gathered round the table: the senior debt pros – Leach and Hamilton – have helped take their banks to the top of the league tables. These institutions are now accustomed to delivering very large chunks of senior debt where a significant percentage is sold on by their sales teams to a hungry group of investors. Petrusic and Hill are mezzanine specialists: their job is to put money to work in transactions that they expect to stay invested in for two to three years and where the rest of the financing group (banks and sponsors) are expected to be staying put too.

Given this difference of objective, it doesn't surprise that the mezz men point out that there are already signs that the current ready (or over-?) supply of straight debt finance is narrowing their investment options: “Everything will often be right except the leverage when we look at a deal,” says Indigo Capital's Collins. “You're seeing some lovely credits being swamped by the bankers pushing the leverage to the absolute limit.”

Leach and Hamilton don't at once go on the offensive but instead through the rest of the discussion there are occasions where they remind the rest of the group that the market – and not just the bankers – are shaping the deals that get done. Sponsors are happy to see the amount of equity they commit come down as a percentage of the total deal size [it can now be much nearer to twenty rather than the recent thirty per cent minimum], and buyers of debt, especially CDO and CLO funds, continue to mop up all of the available paper across the entire yield and maturity spectrum.

The issue of over-leveraging a company to the extent that it founders is clearly a concern that all of the participants sat at the table are alive to. Hamilton is quick to counter Mostyn-Williams' suggestion that the senior lenders are less exposed to a deteriorating credit because they will have sold down a significant piece, if not the bulk, of the debt. Although such a scenario is nowadays typical, given the sheer size of some of the transactions involved and the ready demand for such paper amongst the buy side, RBS, says Hamilton, is “quite a big holder of paper on deals that we do.” Leach adds that: “It is no coincidence that the big banks at the top of the league tables have big balance sheets.” And Hamilton goes on to highlight what he calls “reputational risk” where investors will begin to spurn offerings from banks who in the past have sold them issues that deteriorate: both he and Leach, he says, cannot afford to do this because “if deals go wrong they return to haunt you. And buyers will push back.”

Getting the leverage right for a particular credit means not only that the financing mix has to fit, but also that the lenders' understanding of the company concerned has to be more than adequate. Everyone agrees with Leach when he says that “to achieve top quartile leverage a credit must have a good story you can hang your hat on,” and each participant goes on to stress how important rigorous credit analysis has become. Says Petrusic: “The quality of credit decisions has got far better and the Americans have bought over a ton of experience when it comes to sectors.”

But the prevailing obsession with gauging a company's credit-worthiness via its Earnings Before Interest Tax Depreciation and Amortisation, or EBITDA, bothers the group: all complain that as a market indicator EBITDA is not meaningful enough and that EBIT [Earnings Before Interest and Tax] is preferable. Petrusic for one is also keen to offset the rise in increasingly complex financing structures with the more fundamental, shop-floor kind of analysis – “these businesses have to make things” – that can confirm these companies can really sustain the debt levels being loaded on them. “At times you'll find the only reason that the leverage is going down is that the EBITDA is going up – not because the cash is being used to pay the debt back. That's the problem: you look at the company and say 'hang on we've not achieved anything, we've actually stood still!”

The right sponsor
Finding the right sponsor partner is another critical component to a successful financing. Says Leach: “Sponsors’ approach to diligencing the deal is very important: the top 15 to 20 sponsors are uniformly thorough in terms of their approach to a transaction.”

“And don't forget,” adds Hamilton, “that we are now typically looking at transactions where these sponsors are putting a significant percentage of their funds into a deal. They may be investing in only five or six companies through the life of a fund and that means each one of these matters hugely. These guys will be very thorough and focussed.”

They will also be pretty demanding when it comes to talking to prospective banking partners for a deal. Given the marked increase in competition amongst the banks to participate in LBOs – be they small, medium or large – it is clear that the banks have set themselves up to move ultraquickly when the call comes from the right sponsor. So is making the decision to get involved a difficult one?

“I don't think that process is very tough,” says Hamilton. “It all happens very quickly in your head over the course of thirty seconds: who has phoned me and why. If one of your tier one houses phone, it would be fairly unusual to turn around and say ‘actually I'm not all that interested without even looking at it, thanks very much’.”

This prompts much laughter from the rest of the group as clearly even the thought of such a response seems preposterous. The lenders have evidently spent considerable time and effort getting to know the sponsor community to the extent that they have segmented this group by, amongst other things, specialisation, aptitude and appetite.

RBS is just one major European debt provider that has worked very hard to get to know the US buyout firms now active in Europe for example. These heavyweights (including KKR, Blackstone, Texas Pacific and Bain Capital), alongside such European houses as Apax, Candover, Charterhouse, CVC, Cinven, EQT, PAI and Permira, all of whom are managing multi-billion Euro funds, are buying some of the largest assets for sale in Europe and the income potential from such transactions has not been lost on any of the major banks, let alone the aspirational lenders.

Amongst this group of sponsors there is ostensibly little to distinguish in terms of skills and resources. Nonetheless, the banks want to make sure that they are comfortable closing in on a transaction with a preferred partner. Says Hamilton: “For your tier one houses you say to yourself 'a pound of their equity is probably worth two pounds of somebody else's, and when they phone me you can bet that I will be working as hard as I can and giving them what they want. You've already done the diligence: you've said ‘these people are good at this, not so good at some other things, I like dealing with them, they treat me like this…’ Not all of these things will get positive ticks but you've made a decision, so when they phone, you're off and out to help.”

When assessing the GP there are a range of commercial and strategic criteria the lenders are using. Some of them are straightforwardly pragmatic: a number of GPs have developed a reputation for squeezing the banks on fees to an extent that many lenders will have second thoughts on responding to an approach.

Other sponsors make a habit of inviting a host of banks to bid for a mandate and although none of the participants said they have a problem with competition, several confirm that taking part in an eight-horse race to win a mandate is not going to be near the top of their priorities.

Other criteria are more fundamental: a lender will look closely at why the sponsor is looking to buy a particular asset for example. Does it fit within their declared area of sector focus? Do they have the team to apply relevant skills to it? Is it a coherent part of a build-up strategy?

Comments GSC's Petrusic: “With our mezz fund, we have turned down deals in cases where in our judgement the sponsor wasn't right for the deal, because they didn't have the right skills for an asset they just bought.” And rejoins senior debt man Leach: “You're probably more sensitive to that because as a mezzanine provider, you're obviously dependent on a performance level that is above what banks as senior lenders need.”

Recaps and equitisation
This comment serves as a telling reminder that mezzanine – often referred to as cheap equity but expensive debt but which nonetheless has helped bridge many a financing gap in a buyout – occupies a different place in the capital structure of a deal to senior debt. And its practitioners look at a transaction from a different perspective.

It's not surprising therefore that at this point, the conversation turns to how transactions are evolving post acquisition – and how equity sponsors are today more likely it seems to recoup their initial investment via a recapitalisation.

The mezzanine firms are evidently concerned that the sponsor loses some of their hunger and engagement with the asset if a recapitalisation happens – especially if it's number of recapitalisation deals around at the moment where the banks and the mezz guys are being asked to refinance the business – and if it's done well the sponsor will get all their money back. As a house, we have certainly sharpened our thinking as to whether or not we ought to do these deals, depending on whether it's a complete repayment or are they leaving at least some of their original investment in the deal, and who it is we're being asked to support. Because there have been examples of deals in the market in the last two or three years where the experience of the lenders has been less than happy. We now look at the sponsor and say: ‘Are you in or are you out – we need to know.’”

Barclays Capital's Leach adds a banker's perspective on recapitalisation and sponsors' withdrawal of their original commitment: “It used to be that banks were very nervous about equity coming out of a deal before debt. But recently you've had probably seven or eight deals where most if not all of the principal has come out. Now, maybe the debt market is a bit more sophisticated, saying that if the equity sponsors are looking to make two or three times their money, then even if they have virtually none of their original investment on the table, it's still important for them. And if a deal goes wrong, even if they had a 100 million still in, sponsors are not necessarily going to throw good money after bad.”

This latter scenario, where a leveraged company begins to weaken and the risk of default increases, is obviously a central concern for everyone but it is those who have equity, or equity-like risk (aka mezzanine), who are most exposed – unless the sponsor has managed to recapitalise and retrieve their original investment.

As a seasoned leveraged finance lawyer Mostyn-Williams is well-placed to comment: “I think what needs to happen is for people to look at the different structures and pressure points in terms of the rights of the various parties in recaps, particularly with regard to the subordinated debt piece. Now people are recognising there are problems because there are actually some quite stark situations for the subordinated debt holders here.”

Petrusic responds with the mezzanine perspective: “The subordinated holders will simply say: ‘OK, now you have to pay me for this risk’, and that's where they hit a brick wall. We have turned down a number of recapitalisations, because given the risk we were effectively being asked to be the equity in the deal. If something goes wrong, what is going to happen? The banks are not going to pay the mezzanine holders their interest, which is fine. But now the business needs to be restructured, and who's going to pay for that? Equity won't put in any more money, the banks say ‘we can't put in any more money, we're at six times now’, so mezzanine must be at 7.5x. But you can't sell these businesses at 7.5x, so now what do we

Mostyn-Williams responds by putting a name to this issue: “That's equitisation. It's following on from what we've seen in the high yield market where so many companies, not so much buyouts, but TMT businesses, are all owned by the high yield investors. That's why I say maybe the historic structures need to be looked at again, and maybe pricing needs to be looked at again.”

This year and beyond
If pricing is a perennial factor when winning an LBO mandate, its legacy for the company has become increasingly hard to discern in the early life of the deal post-acquisition. The pricing may be right for a credit in today's market, but the group wonders what the increasing proportion of late maturing paper in a deal would mean if the interest rate environment becomes less benign.

Comments Leach: “60:40 used to be the classic amortising and non-amortising senior debt ratio in a transaction but this is now reversed in some deals. There are also now big chunks of mezzanine in the mix. This means that the drain on cashflow to service debt in the first two to three years of a deal is far less significant which can in certain cases disguise overleverage.”

Hamilton chimes in: “If amortisation kicks in, in a tougher interest rate environment, then some of these businesses will start to struggle.” The consensus is very much that the surge in eight and nine year dated senior paper used in a growing number of deals has the benefit of taking a huge weight off cashflows in the early years but that it is not as if the obligation to service this portion of the financing has gone away. If interest rates rise or – as many companies with US dollar revenues know all too well already – currency volatility continues, then life as a leveraged credit will become that bit more stressful.

The lenders are clearly alive to the dangers of building in problems for tomorrow by pushing leverage to what seems to be a sensible maximum by today's standards. As part of this, they are having to give and take with the sponsors – who are keen to exploit the much more competitive lending environment and the inclination for some lenders to accommodate more favourable terms and more unusual financing structures.

With these factors in mind, how does each of the group view the year ahead? Mostyn-Williams has no doubts: “I'm very optimistic, there are lots of good deals out there and business confidence is coming back.”

“I agree,” says Hamilton but then adds a note of caution: “I also think we will see something of major size falling over.”

The two mezzanine specialists are a little more circumspect. Richard Collins is “reasonably confident that 2004 will be better than the past two years but I'm concerned about the Euro-dollar exchange rate in terms of pan-European transactions. Most businesses hedged for movements last year, but this year there's a time bomb ticking.”

And Petrusic: “I'm positive about the business environment and dealflow. But we will also see more refinancing and more secondary buyouts because I think the IPO market is still going to struggle to satisfy the exit requirements.”

Finally, Leach: “I'm generally positive. Liquidity in the debt markets has been very strong, and one wants that to stay that way. But we have started to see some excesses: if the market starts to lose its discipline it would be a worry.”

European leverage roundtable: the participants
Richard Collins is a director of London-based mezzanine house Indigo Capital, which he cofounded in 1999. He is responsible for the firm's operations in France and other Frenchspeaking markets. Indigo is now investing its €475 million fourth mezzanine fund, primarily aimed at medium-sized growth companies.

Euan Hamilton is global head of Royal Bank of Scotland's leveraged finance and mezzanine businesses, which he has been part of since 1996. Together with colleagues Leith Robertson and Eric Mallaroni, Hamilton has helped cement the bank's position among the most active providers of LBO funding in Europe.

John Leach is a managing director of Barclays' leveraged finance business, which topped the European leveraged loan tables in 2003. Prior to joining the bank in 2000, he spent ten years at Paribas in London and Paris. Recent transactions he worked on include Seat Pagine Gialle, Ontex and Rodenstock.

Stephen Mostyn-Williams has advised on some of Europe's most high-profile LBOs to date. He joined Cadwalader in 2002, having worked for fellow law firms Ashurst Morris Crisp and Shearman & Sterling as well as London-based investment boutique AIG MezzVest. He also chairs the European High Yield Association.

Nick Petrusic joined GSC Partners as a director in 2000 having started his career in European leveraged finance in 1990 while at Natwest Group. At GSC, he is a senior member of the team currently investing GSC European Mezzanine Fund LP, a leveraged mezzanine fund capitalised at over €1 billion.