Refinancing: An LP Perspective

Q – Are investors in European buyout funds generally focused on leverage and the refinancing challenge or are some still surprised by the concept and reality?

Since the peak of the debt market in 2007 and the subsequent market meltdown, most people are on the same page. General partners as a whole have been good at communicating information to investors about debt multiples, covenant status and debt maturities. At this stage, four or five years into the crisis, most of the investors are conversant with what the issues are in their portfolios and know where value is potentially at risk or impairments are likely to take place.

Q – What sort of issues are you hearing your peers talk about?

The issues that are being talked about are: availability of debt; the multiple of debt to EBITDA; the margins that the debt is incurring and the covenant position with respect to existing indebtedness; the multiple/rate of paydown and, of course, the refinancing wall. Generally speaking, people are looking at these issues on a portfolio-by-portfolio or manager-by-manager basis rather than taking a view from a broader market perspective.

Q – Are managers communicating well enough with their investors about debt-related issues?

Following the 2008/09 market meltdown and the concerns about debt multiples, the ability to pay down debt, to meet amortisation schedules and the covenant position of companies, GPs have had to improve their level of communication. Of course, I wouldn’t expect a GP to communicate with me on every element of a refinancing that is taking place; however, when it’s one of the larger investments in the portfolio, which may have covenant or maturity issues, you would certainly be expected to be communicated with. And just being informed at the annual meeting or the advisory board meeting would not be sufficient. I would also expect to be informed by way of an email communication at the time of a refinancing taking place. This approach is becoming increasingly more common, which is a positive sign.

Q – In your opinion, has the concept of amend-and-extend had its day?

There is a limited banking market in Europe at present and buyout managers have to work with their existing banking relationships. In many instances this is preferable as they understand the respective credit in each company. These are not amend-and-extend deals from the position of weakness on the part of the company or an indication of some form of distress. Rather, these are amend-and-extend deals where managers wish to hold the asset for longer either to increase earnings or because the manager perceives there to be potential problems with exiting the investment because multiple options are just not available.

Q – Would you say that investors in buyout funds are seeking out managers with appealing leverage strategies?

Institutional investors are taking more time to understand how managers have created value historically, including through debt strategies, and how they are likely to perform in the future in a weaker economic environment. It’s not the number one criterion, but it is increasingly important in manager assessment.

Q – When you consider the market do you think all of the companies that will be seeking refinancing will be successful in securing it?

No. Where there has been significant impairment in terms of EBITDA or the financing structure has been too aggressive and you’ve seen debt investors investing with the sole aim of creating a buy-to-own situation there may be complications. Where the business has a credible strategy and where there has been EBITDA evolution over time then there is a likelihood they’ll be able either to amend and extend the existing facilities or refinance with new facilities, albeit at higher margins than at the top of the market.
There is still an issue out there for some of the 2006 and 2007 deals in particular, where there has been some reduction in the debt multiple as EBITDA has increased or debt has been paid down, but there has not been significant equity enhancement for the funds. Banks seem to be more comfortable taking control today than they were in the early days of the financial crisis, but they are still reluctant to do so. Hence we have seen flexibility in restructuring.

Q – Do you consider that some of the companies will become distressed candidates?

Some of them undoubtedly will – it comes back to the point that some will be willing and able to secure refinancing and some will not. Some of those companies that have seen significant EBITDA impairment have already failed, but there are other companies with aggressive structures that the debt funds have bought into in a buy-to-own strategy to gain equity control.

Q – When you consider those companies that are likely to be successfully refinanced and those that are not, does this knowledge and awareness colour institutional investors’ appetite for certain investment strategies going forward?

It’s obvious to state but there were certain sectors where deals were done at very high EBITDA multiples, driven by cheap debt. Many of these companies are good operations but with the wrong balance sheet. We consider that a successful refinancing has more to do with the work that the private equity fund has put into the specific deal from an operational perspective to make it perform better. No-one is being seduced these days by advisers saying this sector or that sector deserves a higher multiple. People are generally much more cautious on structuring deals today. What is clear is that investing in specific debt strategies, be it trading, distressed, loan-to-own, mezzanine or leveraged debt can deliver decent returns for institutional investors and is a diversifier from equity returns. The high level of capital raised for these strategies is reflective of investor’s appetite.

Q – How well are managers generally disclosing developments relating to refinancing processes?

Certainly at advisory boards and at annual meetings the level of disclosure is pretty good. The key investors on advisory boards are being kept appraised of developments, but smaller institutional investors may be seeing managers less. So there is probably a need for these smaller institutional investors to be more proactive. I have always found managers have been willing to answer any question their investors pose. They are generally pretty good in communicating but depends on the forum. If smaller investors do not secure what they want at events such as the annual meeting, they should contact the manager with specific questions.

Q – Are you finding there is a consideration that managers are seeking further equity injections from investors as part of or instead of seeking refinancing?

In the first instance managers are looking to refinance through the debt markets. It is only in extremis that they are looking to come back to seek further equity. We can commend many managers for being very good at reserving equity, whether for equity cures or buy-and-build purposes, in their 2005-to-2007-vintage funds. In many situations where companies have been able to refinance, the quantum of debt available is reduced and equity is required to fill the gap. The fact that average debt multiples have reduced from 7.0x EBITDA to 4.5x EBITDA means that companies that have not already reduced to around 5.0x EBITDA will face difficulties without that equity element.

Q – What about other sources of liquidity such as the European high yield bond market?

Looking back at the high yield bond market in 2012, there was record issuance somewhere in the order of $55 billion for LBO sponsors and non-investment-grade corporates. The European high yield bond market has been very helpful when considered on a volume basis.

The private equity managers are certainly actively aware of other sources of finance available in the market. They should be communicating these other sources of finance to their limited partners, as our managers are communicating with us. As I mentioned in my opening comments, we spend a lot of time looking at the market from both bottom-up and top-down perspectives. One of the benefits of being part of the broader Standard Life Investments house is that as a team we have a great understanding of current developments in the high-yield bond market, as opposed to only relying on the private equity managers.

Q – What is the outlook for the European high yield bond market 2013?

It’s a market you have to judge quarter by quarter. If you look at the first half of 2011, for example, the amount of high yield bonds was very robust but then the market shut in the second half of the year. In 2013, a lot will depend on what happens in the broader macroeconomic context and political environment, particularly around the euro. The latter is going to have a big influence on individual geographies, on credit and the demand for fixed income generally.

Q – Beyond high yield, are there other sources of finance relevant to European buyouts refinancing?

The bro ader issue is the emergence of secondary lenders which are coming to the foreground – well-funded smaller groups, pension funds and structured funds will be providing credit rather than the traditional banks.

Q – Will private debt turn out to be cyclical trend?

A lot of this is driven by the fact that the banks have moved away from the leveraged loan market. If the banks don’t come back, then there is going to be a continuation of these alternative sources – someone will fill the gap where they see attractive returns. The last couple of years have taught us that the European high yield bond market is also a potentially robust alternative for the future.

Q – Will banks to play less of role in European buyouts going forward?

I think the banks should have a very important role to play and it would be sad to see them moving out of the European buyout market, which has been a remunerative area of business both in terms of fee and margin. There is a continued opportunity for the banks, but many of the issues they face have been created through politics and other more important issues that they face. Leveraged loans are a relatively small part of their portfolio in reality so how much attention will it get?

Q – Do you think there are enough finance structure innovations?

I think there are many great ideas out there but not all of them are being implemented. That’s one of the ongoing challenges: to be able to put good experienced teams together to be a credible alternative provider of debt funding. We would contend that reducing the complexity of leveraged debt structures is helpful for limited partners – it forces the managers to place more emphasis on operational improvement to drive value rather than expect returns from a racy financing structure.

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