The return of the triple track process

The UK market for alternative debt providers continues to grow apace. There are around 50 providers currently in the London market, compared with just over 20 two years ago. The numbers keep on rising, in quarter one of 2014, EY’s debt advisory team received a call at an average of about one a week from a new debt fund, anxious to spread the word, or in many cases from a potential new debt fund that had not yet even set up.

The funds have a wide variety of origins. Many are well-known mezzanine names, such as ICG, that have taken up senior lending. Others are offshoots of private equity houses, such as Blackstone’s GSO and HIG’s White Horse. There is European money too: for example Tikehau from France and Proventus from Sweden, as well as Islamic, and of course, US money.

Investment parameters vary enormously as well, with some funds looking to compete with, and even join, banks on club deals and others looking for those special situations, where banks can’t compete, but where they believe the credit, and therefore the return, is attractive.

There are a number of attractions for both private equity houses and non-sponsor companies. The prevalent product, unitranche, provides a “one stop” financing solution, with no intercreditor agreement, and is typically provided on an interest-only basis, allowing the borrower greater flexibility with its cash flows.

Against a background of stiff competition in the sphere, pricing is falling for the more vanilla credits, such that the gap with bank debt no longer looks so large, whereas appetite for the trickier credits is on the increase. The effect of this has been to create something that has begun to look like an arbitrage vs M&A, rather than the M&A driven debt market that was forecast for 2014.

In reality, M&A has only really been a driver for the very best assets, typically those trading on double digit multiples. For those at the single digit end of the multiples range, recap is now an important alternative to M&A, a process that started almost accidentally in 2013, whilst private equity houses were engaged either in formal or informal sale discussions on their assets.

What these processes often revealed, was that whereas the multiples actually achievable for their assets often fell short of what was desired – let’s say a hoped-for 8 x became 6 x – the funds’ appetite for leverage that might have been 4 x or more for a sale was only dimmed marginally by the prospects of a recap. Hence what is achievable on a recap, with another “throw of the dice” on the equity, is beginning to look remarkably close to what might be achievable as a result of a sale itself.

Given the current enthusiasm for IPOs, this is often linked to an IPO process, giving a private equity house effectively a triple bite at the cherry – some initial explorations of M&A, which are soon discounted, a recapitalisation to achieve the “bird in hand” return, followed by a “de-risked” run at an IPO process. The triple track of the boom years is effectively back, except now, rather than running these three exit options in parallel, they are typically done over 12-18 months as a sequential process.

The versatility of the recapitalisation, and the opportunity it creates to seize returns immediately means that in 2014, it is here to stay and is now an accepted milestone on an asset’s path through a PE portfolio, rather than the “poor relation” outcome. So much so that we have now even begun taking recapitalisation work from turnaround specialists, and seen good appetite from funds ready to allow an effective exit to those funds, whilst preserving additional upside for them.

Bridget Walsh is a partner and head of private equity for the UK and Ireland at EY. Greg Moreton is a director in the capital and debt advisory team. Both work in EY’s London office.