Pricing pressure

Debt has never been cheaper, but it may have finally bottomed out.

Low interest rates, relatively low default rates, reduced pricing, massive liquidity in the market has led to continued pricing pressure on all tranches of debt in leveraged buyouts in 2006.

But Fenton Burgin, a director in Close Brothers debt advisory group, thinks pricing may have hit a floor. He says: “2006 has seen us move away from the ’standard’ 225,275,325 basis points grid; this year we’ve seen more deals with reverse flex and pricing coming in 25-50 bps lower across the piece. However, at 200bps on the A loan we think that you are close to the bottom given that this is many institutions’ hurdle rate. Recently, we’ve seen a flurry of deals in the 200, 237.5, 275 basis points pricing zone.”

Burgin also notes this year has seen other industry benchmarks move. In particular the strips of amortising debt have all but disappered.

He says: “Historically, we would have expected to see a significant element of amortisation in mid market LBO structures with a 30%, 30%, 30% distribution across the A, B and C tranches with a junior piece of mezzanine making up the balance. Today, we are seeing far larger elements of deals being placed into the institutional led, non amortising B & C tranches with smaller A loans that have heavily back-ended amortisation.”

In addition Close Brothers has seen equity contributions in deals falling in 2006. This is confirmed by recent S&P data, which show average LBO equity contributions running at about 30 percent compared to closer to 35 percent in 2004/05.  Enterprise value EBITDA multiples are now running at eight year highs at in excess of nine times according to S&P, the ratings agency.

Close Brothers first saw US style institutional structures in Europe last summer on the Apollo €920 million Ish/Iesy cable deal. Burgin says: “The new institutional deals show a range of approaches, but resemble traditional B and C tranches with maturities of eight or nine years. Some institutional deals such as PHS have A and B bullet tranches, some have B tranches only and, for example, Elior has B1 and C1 tranches. All however have no amortising debt.”

S&P recently estimated that bullet repayments accounted for 75 percent of principal in European buyouts in the first half of 2006. Recent examples include the facilities supporting Candover’s €1bn acquisition of Swedish mattress maker Hilding Anders which carried aggressive leverage multiples at greater than seven times, according to Close Brothers, and was structured with no A loan.

Other examples of the weight of institutional money impacting structures in mid market deals include the £430 million debt package backing Lehman Brothers Co-Investment Partners’ acquisition of a 36 percent stake in Firth Rixson that was structured with no A tranche.

After good support for the deal and an oversubscription across all tranches, part of the the structure was reverse flexed down 25 basis points.

Burgin says: “The more remarkable feature of 2006 has been the way in which some medium-sized companies have been able to access multiples historically reserved for far stronger credits. We have seen structures pushed to the limits in a number of highly competitive buyout auction situations over the summer months.”

In part this liquidity has been driven by banks’ ability to lay off the resultant highly geared structures in the institutional market. Burgin says: It is also fair to say that private equity firms have taken advantage of the ’spray and pray’ mentality of some lenders. Many bankers can point to deals that they believe to be over leveraged – the real question for 2007 is which ones will not survive in their current form?”

S&P estimates that the average gross debt multiple on European LBO’s increased from 4.2 times EBITDA in 2002 to 5.4 times by June 2006. Burgin says: “At these sorts of levels you are not into a simple covenant reset exercise when the company fails to meet business plan.”