Capital Talk: Life inside the Capital Structure

'Debt' and 'value creation' don’t typically go hand-in-hand when one thinks of private equity. For many, the asset class is synonymous with debt, but for all the wrong reasons. The highly levered buyouts of the pre-Lehman era came to represent excess: big firms, big tickets, big debt to EBITDA ratios. In Europe, firms like Permira battled and sometimes partnered with US heavyweights like KKR, Blackstone and Carlyle. Several years on from those heady days, were the critics proved right?

Permira’s Maximilian Biagosch doesn’t think so. Private Debt Investor meets him on an unusually bright and spring-like day in London, the weather perhaps reflective of the sunlit uplands to which the firm intends to claw its way after a torrid period of fundraising and portfolio management.

It is this the last point which sees Biagosch open up: about the need to understand what it is to live with a capital structure on a daily basis, about the need to use debt creatively and sensitively, and about the need to be proactive.

“Clearly the environment has changed. Six or seven years ago as markets were going up and financial engineering was a more reliable source of value creation than it would be today. I also think risk awareness has changed across the industry,” Biagosch says.

“But financing is not an end in itself. It is there to support the value creation in the investment and as such it must be geared to provide operational flexibility, flexibility to make acquisitions and support any other expansion strategies. The right capital structure is one that makes management’s job easier and supports growth and value creation.”


Be a banker and an investor

Permira’s financing team has always been geared towards this approach, with every member essentially ‘double-hatting’, operating as both an investment professional and financing expert. It’s a key requirement, Biagosch – himself a former leveraged finance and high yield banker at BNP Paribas and Deutsche Bank – argues.

“Unless you’re an investor yourself you won’t fully appreciate and understand what it means to live with a capital structure for the duration of the investment.

“Because we try and support the investment by putting the right capital structure in place, we have to understand what drives the investment on a day-to-day basis and what drives value creation operationally before deciding on financing. We deliberately chose not to have a group of ‘internal bankers’ who are functional experts but don’t really understand investing, but instead to have investors who are also functional experts in financing.”

Understanding both the debt markets and the needs of portfolio companies has enabled the firm to grasp the refinancing nettle over the last year or more. In the first four months of 2013 alone, Permira completed a staggering €5.5 billion-worth of refinancings. The firm’s proactive approach has driven overall leverage in its Permira IV portfolio down from 5x to 3.6x today, according to the firm.

“Everything we’ve done has been opportunistic, which is great because you proactively help to generate equity value for your investors,” Biagosch explains. “We didn’t have to do any of these [refinancings] but we chose to, and I think that’s broadly reflective of the market. Of course there are a few tough situations out there but those are not the ones that really benefit from the current market being constructive and being able to support strong execution.”

The market has certainly been supportive, both in Europe and in the US. “The financing markets have been very constructive over the last six to nine months in particular, and indeed for the best part of 18 months,” he believes. In particular, the high yield market in Europe has thrived over that period, and has gone some way to replacing loan liquidity, “a significant and pretty transformational feature”, Biagosch believes.


Good leverage

What remains of the leveraged loan market is actually in better health than some might think, he adds. “It’s good, although it’s not quite as amazing as some people may think because it’s very binary. By that I mean it’s great for very good assets but it’s actually not that great for average or mediocre assets,” he explains.

“It is a relatively discerning market – for example, if you look at the number of dividend recaps that have happened there have been very few of them. They’re only possible for the best assets and only at reasonably conservative levels.”

No-one is quite sure what the European market will support in terms of new-issue debt, Biagosch believes, because primary issuance has been such that no-one has really tested liquidity or appetite. Refinancings have instead come to the fore.

There’s been a telling difference in the level of re-pricing between Europe and the US, he believes. “There have not been that many in Europe. This is reflective of the European market being less institutionally driven with a less liquid secondary market compared to the US market. The European market is therefore less quick to respond to changes in the market environment.

“The US is a different market in that it is much more institutionally driven. It has benefited for a long time from a very liquid and deep high yield market. It has enjoyed stability in terms of primary pricing and activity as well as a more liquid secondary market – and so re-pricings have been much more prevalent and easier to execute.”


Reshaping the portfolio

That has allowed liquidity has helped Permira refashion the debt components of many of its portfolio companies. The firm has either refinanced or re-priced its entire US portfolio (except its recent acquisition, a December deal). In Europe, its turned the capital structure of travel business OdigeO into an all-high yield one, while in Asia, it’s refinanced both satellite company Asia Broadcast Satellite (ABS) and Japanese sushi chain Akindo Sushiro.

“Akindo Sushiro was a bank-led refinancing in the Japanese market for a domestic Japanese asset. We made some structural adjustments in order to optimise the operational flexibility of the business. It has been a strong performer since we put the original capital structure in place. There was no increase in leverage or dividend but rather a re-pricing, reflecting that the business is now a more established and proven performer.”

The Akindo refinancing was precipitated by one of the company’s “very strong bank club” proactively approaching Permira to suggest a refinancing. The banks started to compete with each other which drove the execution forward. “It’s the sort of thing that would only have happened in this type of market,” jokes Biagosch.

And what of those boom-era deals lurking in Permira’s portfolio? Freescale, at $17.6 billion, was a top-of-the-market deal when it completed in 2006. At the time, The Carlyle Group’s co-founder David Rubenstein told The Wall Street Journal that loan covenants were so loose, “they make you wonder if you can default at all anymore”. The deal raised eyebrows for the substantial debt package used to underpin the buyout.

Restructuring that debt could in theory be made more complicated by virtue of it having been a club deal. Permira acquired the semiconductor-maker alongside The Carlyle Group, TPG and The Blackstone Group.

Speaking generally about working within club deals, Biagosch says: “Partners can sometimes have differences in opinion; if so, management typically acts as an interested and rational arbiter because there’s money at stake for them. Typically if it’s the right thing to do for the company, it should be the right thing to do for both or multiple shareholders.”

With Freescale, debt maturities have been pushed out to 2020 and came at an “attractive” price, Biagosch says.


The refinancing wall

When people talk of a ‘refinancing wall’, it’s tempting to think of large pre-Lehman buyouts as those which contribute chiefly to the €46 trillion of buyout debt that will approach maturity in the next few years. Yet this is misleading, Biagosch insists.

“For the stronger, larger, well-run sponsor-backed businesses that have done what we’ve done which is proactively address portfolio issues around capital structures, this is a great market because you can opportunistically improve capital structures.

“For other sponsors, the smaller ones perhaps, possibly with a less structured approach and who are active in the less liquid segment of the market, it may well be that without this current credit environment they would have had a much greater issue. When you look at the overall numbers the greatest refinancing challenge lies with this small to medium-sized segment of the market,” he adds.

And it is in this segment that the new wave of private debt funds will find many attractive opportunities because the need for financing is so acute, he believes.

The arrival of new sources of credit, and the growth of existing non-bank debt providers, has given sponsors at all stages of the buyout spectrum more freedom when piecing together debt packages.

That flexibility has allowed firms to completely refashion capital structures in some cases, as Permira did with OdigeO. Originally a blend of senior and subordinated loans, Permira took the opportunity earlier this year to refinance the senior loan and turn it into a senior secured high yield bond. In tandem with that, the revolving credit facility became a super-senior bond. “We turned a deal which originally had a loan and bond structure into a pure play all high yield structure,” Biagosch explains. It also brought leverage down from 4.3x at acquisition to 3.8x now.

“The reason mainly was to support the value creation story by adding operational flexibility – an all high yield structure for this type of business is better suited to support the growth strategy that the company is pursuing, both organically and through potential acquisitions. The management can focus purely on the business without having to report back to investors regarding maintenance covenants and so on.”


A new bubble

The growth in popularity of high yield has prompted whispers of a bubble emerging, but Biagosch rebuts such accusations.

“I don’t believe there’s a high yield bubble in non-investment grade land. What constitutes a bubble is irrational pricing relative to the risk that people take on. We’ve just tested the risk of the high yield markets or general loan and high yield markets over the last five, six years pretty robustly, yet default rates remained stubbornly low. And if you look at the pricing relative to the risk adjusted return that are available from other asset classes, in Europe it still looks pretty attractive which is why quite a few US-based investors and
dollar based investors are now looking at Europe for better pricing and yield opportunities,” he says.

That’s not to say the European high yield market is immune to macro shocks of course. As Biagosch admits, increased volatility could cause it to correct or even shut temporarily. But as he points out, it has proven remarkably resilient despite a torrid 18 months which saw sovereign bailouts and doubts over the future of the single currency.

“There were real question marks around the survival of the Euro around the time of the Greek elections in late spring 2012 but the high yield market did not shut. That was at the time pretty much unprecedented. So for the high yield market to re-price rather than shut in Europe in response to those types of macro concerns to me was a new and every encouraging thing,” Biagosch says.

“Since then, despite wobbles such as Cyprus, the market didn’t shut. Instead it just adjusted and that is what a functioning, liquid and more mature market should do. That is hopefully a sign of the European market now being deeper, more liquid, more established with a more stable investor base that allows that market to remain open despite some volatility which as we know will continue,” he adds.

High yield won’t always be appropriate of course. It only suits companies above a certain size, and some businesses (and their private equity backers) may not want the requirements for public reporting that come with a bond.


'Stretch senior' and unitranche structures

High yield is also just one tool in an extensive kit however. Whilst the number of products may not have increased much, if at all, since the earlier 2000s, sponsors’ willingness to use a variety of them has certainly improved, Biagosch asserts.

“If you take a bog standard, medium-sized €500 million to €1 billion LBO in Europe today, you wouldn’t necessarily look at the classic structures that we’ve seen previously. Clock back to 2002/03/04 and we would have seen a senior and mezz type structure, while in 2006/07 we would have seen a senior plus secondary lien plus mezz plus maybe a PIK structure. But people have learnt their lessons from the difficult period that ensued and look much harder at what is the right capital structure today and what best serves a particular asset at a particular stage of development.

“Today you see more senior-only structures. You see unitranche structures. You do still see senior plus mezz. You see bond-only structures to support an acquisition with a bridge into the bond structure underwritten at the time of signing the deal. You see loan and bond structures. There is much greater use of the different options in response to the particularities of each individual’s occasion. I think people have gotten smarter about how they finance businesses,” he adds.

Biagosch points to ‘stretch senior’ and unitranche structures as interesting potential financing solutions. “These are good if you’re looking to create value by transformationally growing a good business and need to retain operational flexibility and want to take care not to overleverage the structure,” he says.

Here is another segment of the market where new providers of debt have grown increasingly influential, Biagosch argues. “The investor base has shifted so you see more credit funds; non-bank lenders and non-CLO money plays a much greater role now. You can almost create a club of institutions these days who have a relationship approach, who are capable of doing good credit analysis and of writing larger tickets.”

Private equity firms have in many cases come to understand these non-bank lenders better as relationships have developed.

“Sponsors have grown comfortable working with these managers over a period of time. Looking forward, you ask, who has both the willingness and the ability from a balance sheet point of view to support growth – be that via capex projects or acquisitions? And can they be creative and flexible when it comes to really tailoring structures to that particular situation? That’s what you’re looking for.”

A closer relationship between borrower and issuer (and other stakeholders) certainly seems to be in vogue. One thing now is that you’re much closer to the investors in your debt. So on high yields for example until not too long ago, it would have been a bit of a black box for your classic traditional sponsor in terms of the investor base that the banks are selling to and therefore very difficult to figure out whether you get the right pricing, whether the structure finds support from investors, just how good the bank execution is.

We now have direct relationships with quite a few of the large important high yield investors,” Biagosch says.

“We speak to them directly. We see them in pre-marketing. We get calls from them. We get open feedback from them, and so I think there is much better dialogue. On the institutional side, we’ve been close to our institutional loan investors in the past but obviously we’ve shifted our focus and effort to staying very close to those investors that matter the most in this particular market environment,” he adds.

It’s all the more important because banks’ appetite for new issuance, particularly of the take-and-hold variety, is much reduced although there are exceptions. “We’ve had a few examples of institutions, including US ones, that have seen their deposit base increase dramatically and they are looking to put that money to work. And one place to put it to work for good yield is in Europe,” Biagosch points out.

“But I think overall bank liquidity has decreased and will continue to do so – there’s been a bit of a respite recently because of the delay in the implementation of Basel III rules which has reawakened the bank lending markets but that is a temporary phenomenon.”

There’s both room and a need for further growth in private debt, Biagosch believes, largely because of the need to find a compensating pool of liquidity once CLO reinvestment periods end over the next year or so in Europe. “Credit funds have not grown quite as strongly as we probably would have expected them to but that is mainly also because of the lack of opportunity in the primary markets,” he adds.

He predicts the European CLO market will improve, albeit slowly, estimating around €3 billion of new issuance this year. “That would be very encouraging. The CLO model based on current funding costs and the yield available in the market is starting to work again. The challenge is where will they [CLO managers] source the product in the absence of more primary activity?”

Understanding this fluid, rapidly changing financing landscape is a key part of Biagosch’s role, and it’s one he evidently enjoys. Asked if he misses his days in banking, his response is revealing.

“No, I think it’s more varied [at Permira], it’s more interesting to me not least because I still do spend time on investing. We have the luxury of being much closer to the assets that we finance and therefore understand better how a capital structure can serve that value creation. I also like the challenge of working across different geographies, very different sectors and working with a group of very talented people. At Permira we are a much smaller team, so I have the luxury of both managing a team and doing execution myself which I very much enjoy.”


Refinancing Genesys

If there’s one deal which exemplifies Permira’s approach to refinancing debt in its portfolio, it’s customer service software company Genesys.

Appropriately enough for a US-based business, Genesys had a US-style capital structure built around ‘cov-lite’ loans.

“With the refinancing, we didn’t actually put any additional leverage on to the business but instead re-priced the structure in light of the different risk profile,” Biagosch explains. “It now has a proven track record of performance. But we also reconfigured it to suit its increasing European exposure – we introduced a Euro tranche in order to better match the capital structure currency with the earnings profile of the company in order to create a natural hedge. We also raised an acquisition facility which we subsequently used [for a bolt-on deal] – we did not have that flexibility in the original structure.”

The company’s net debt to EBITDA ratio has fallen by more than a turn of leverage from 4.7x at acquisition to 3.4x today.

“It’s a classic example of opportunistically taking advantage of a strong asset and a strong market that is supportive of the asset,” Biagosch says. “And when we executed that deal both in the US and in Europe we had almost 100 percent rollover of the existing lender base and significant additional demand from the existing and new investors. The company did well by re-pricing down and creating some additional operational flexibility – it wasn’t about paying a dividend or re-leveraging the business.”