Back to the future?

It’s been a while since Chuck Prince slipped into his dancing shoes. Back in 2007, Citi’s then chief executive notoriously claimed: “When the music stops, in terms of liquidity, things will get complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

The music stopped, to devastating effect, but almost seven years on from that unfortunate soundbite, rising leverage levels in large buyouts in particular have caused some observers to question whether lessons were learnt.

At the peak of the economic cycle in 2007, average equity contributions in leveraged buyouts had decreased to just a third of enterprise value, only one third of deals featured an all-senior structure, and alarmingly more than half of large buyouts had leverage of more than 6x, according to S&P Capital IQ LCD.

After the global financial crisis, the markets recalibrated and banks decreased their risk appetite. The impact of regulation meant banks tightened lending criteria and liquidity in the debt markets dried up. Private equity firms were forced to use more equity in their deals and incorporate less risky structures – this resulted in an increase in all-senior deals.

This trend reached its peak in 2009, when average equity contributions had increased to 53 percent, and 83 percent of deals featured all-senior debt packages. In Europe, there were no large buyouts with a multiple of 6x or higher that year, according to S&P.

RISING LEVERAGE MULTIPLES

Since then the market has, ominously perhaps, started to move back toward the pre-crisis model of high leverage (see graphic).
There are some important differences in the market today compared to 2006/7 which augur well.

Jon Herbert, former head of acquisition finance for the Lloyd’s Banking Group’s leverage finance division for ten years and currently debt advisory director at LDC, the bank’s mid-market private equity unit, tells Private Debt Investor: “Clearly whilst [use of] leverage is growing we are still some way shy of where the market got to in 2007.”

The proportion of European transactions with a pro forma debt-EBITDA multiple of 6x or higher in 2013 – 13 percent – compares favourably with the 51 percent figure for 2007, for example. In the US, it reached 30 percent compared to 60 percent in 2007.

There are fewer deals overall in both markets of course (and fewer large deals, which tend to be highly leveraged, in particular), compared to 2007, meaning averages are more easily skewed by outlying deals.

One explanation for increasing leverage multiples is that firms are simply paying more for assets, driven by fierce competition, readily available debt and a surfeit of undeployed capital. As valuations begin to look frothy, so too do the leverage multiples used to underpin them.

INCREASED EQUITY

In the European market, sponsors last year used less equity in deals on average than in 2013, but this year it’s ticked upwards again (see graphic).

Whilst equity / debt splits in buyouts are certainly an important indicator as far as aggressive structuring is concerned, it’s the leverage multiples which tend to provoke the greatest debate, and indeed cause for concern.

S&P Capital IQ LCD’s Ruth McGavin says: “Leverage is certainly rising for LBOs. The first quarter multiples look pretty aggressive relative to last year. And [anecdotally] there is concern from institutional investors around the market that leverage is rising quickly. We are not very far away from the record-high leverage multiples seen in the boom years.

“As long as demand for senior secured floating rate debt continues, loans will be increasingly aggressively structured from the investors’ perspective. We expect leverage will rise and spreads will compress,” she adds.

There are certainly signs the market is overheating. A low interest rate environment, coupled with a continued supply / demand imbalance could lead to excessively borrower-friendly terms and features on new issuance, increased use of leverage, and a rapid re-pricing of existing loans, S&P warned in a recent report.

That imbalance has arisen due to increased demand from both bond and loan fund managers for speculative-grade paper and the return of the CLO market. Supply in turn has not risen concomitantly, with LBO and M&A volumes still relatively low.

Despite this, credit quality is generally holding firm amid broadly stable conditions in Europe, but if the imbalance continues it “could prove highly destabilising for credit quality,” the rating agency said.

A pick-up in M&A activity could temper the market’s exuberance before it becomes irrational, S&P added.

THE LP AND GP PERSPECTIVE: IN DEFENCE OF LEVERAGE

Alex Scott, a principal at fund of funds manager Pantheon Ventures, believes leverage multiples are high but notes the different lending environment: “You are probably going to get more leverage into transactions today, but the more robust companies which have weathered the downturn well can withstand higher levels of leverage. We should be concerned about excess leverage, but it is certainly not 2007.

“Debt levels are ticking up but it is the conservative type of companies with good quality businesses that are getting underwritten,” unlike in 2007, Scott says.

He is concerned debt is priced too cheaply however. “In many instances, debt looks like it is being given away too cheaply for the security it provides. Yields are very low in the high yield market within a historic context. The debt provided is trying to chase a relatively small number of transactions for the amount of debt that it can provide and it is putting pressure on debt yield,” Scott says.

But for borrowers and private equity sponsors current market conditions are a boon.

Matthew Sabben-Clare, a partner in buyout group Cinven’s financing team, says lessons have been learned from the crisis and the development of the European market after a period of reflection means the threat leverage poses now is not as great as it was in 2007, partly because there is less of it overall, but also due to other factors.

“New deals are generally struck with more flexible covenants and a more conservative business plan. Interest rates are lower than they were. Cashflow cover and interest cover are generally more robust. The reality is that we are encountering an environment where there is less growth in most developed economies than there was ten years ago. Many business plans will reflect that.”

Another important difference is that buyers of loans no longer tend to leverage their own capital, a factor which added to the instability during the crisis.

The structure of the market has altered, Sabben-Clare argues. “In 2007 there were a lot of institutional investors using leverage and they often had covenants linked to the market price of the loans. When the secondary loan market fell a lot of people were forced to sell which sent the market into a spiral. Many buyers of loans had to de-lever,” he adds.

Sabben-Clare also believes debt investors are more discriminating now regarding individual credits. “I think most owners of businesses including private equity firms have the experience of the post 2007 aftermath fresh in their minds,” he says.

Nonetheless, debt is available – in abundance – for the right deals.

Carsten Hagenbucher, a principal at private equity firm Investcorp, argues that liquidity is at a post-crisis high. “There is a lot of confidence and an ever larger number of debt providers wanting to play and who are willing to underwrite.”

From a borrower’s perspective it can be very good he says, but if a sponsor approaches a deal financing merely from the point of view of increasing the valuation, then they might over-leverage the capital structure. If growth is below expectations, owners can find themselves focusing too much on the capital structure instead of remedying the situation, he argues.

“The market is very frothy,” he says, suggesting that we could be at the beginning of an asset price bubble as demand for assets drives prices to unsustainable rates.

At the moment, he believes the total cost of debt remains below 2006 levels. On a mid-market loan in 2006, banks were offering 2 percent above LIBOR, he says. While margins have increased, a lower Libor rate has reduced the total cost of debt to around the same levels of 5 to 5.5 percent. “The structure and terms are very aggressive in our favour,” he says.