European mid-market LBOs

Any debt investor who cannot understand why European midmarket private equity firms are doing so few deals at the moment need only spend 20 minutes digesting the daily diet of geopolitical risks, macroeconomic shocks and generalised turmoil supplied by their newspaper to find an explanation. It is hard for general partners to agree a price with a target company, when there is so much uncertainty in the world.

To the east, Chinese exports fell at their fastest pace in almost seven years in February. To the west, Donald Trump’s strong lead in the race for the Republican presidential nomination makes some investors fear that the global rise in international trade, regarded as an important contributing factor to the planet’s strong economic growth since the Second World War, could be reversed amid tit-for-tat tariffs.

Meanwhile, the possibility that the UK might vote to leave the EU, generating the biggest change in European politics since the collapse of communism, is tempting many private equity buyers to sit on the side lines.

“It’s been a quiet start to the year,” says Symon Drake-Brockman, chief executive of Pemberton Asset Management, a London-based specialist in direct lending to European mid-market companies. “Private equity firms are looking through a harsher lens when analysing the downside scenarios that target companies could go through.”

Looking at the likely outcome for the year as a whole, “2016 will be a quieter year than we’ve had for the past few years”, he predicts.

Market participants say the torpor could last for at least some months more, given the uncertainties. However, many add that if the way ahead becomes clearer in both political and economic terms, there could be a sudden surge in activity.

“Firms have a lot of dry powder. We’re hearing people say, ‘We’re looking a lot of potential transactions. We don’t quite feel comfortable now, but we think we will do deals this year, though maybe not in Q1,’” says Pierre Maugüé, London-based finance partner at Debevoise & Plimpton, the international law firm.

Looking in more detail, the risks are described eloquently by an investor relations specialist at a large European midmarket private equity firm. “We see quite good dealflow for ourselves and we’ve just done another deal – but having said that, everything is in a little bit of turmoil, whether on the credit or the equity side,” he says. “When it comes to the macroeconomic and geopolitical situation right now, my goodness: nobody knows what is going on.”

He lists the US election, which “is progressing in quite a weird way”, a migrant crisis that “is splitting Europe apart”, the slowdown in China, troubles in the Middle East on the back of low oil prices, as well as the Brexit debate in the UK. All in all, “so many different elements contribute to the volatility”.

Speaking as an executive at a private equity firm, “I’m having a hard time finding a safe haven”, he says. “If you’re a UK company that’s very dependent on European business, you might well be scared of Brexit. If you’re a UK company with strong links to China, you won’t be worried about Brexit, but you might well be having a difficult time already.”

Looking across the English Channel to the European mainland: “I’m not sure that Germany is still a safe haven, because Germany is facing attacks left, right and centre over the migrant crisis, which is putting Merkel [the German chancellor] under great pressure.”

TURMOIL EVERYWHERE

Maugüé cites two other groups of companies whose prospects are clouded by the uncertainty. One is European companies that sell into the large British market, given that a vote for Brexit would probably cause medium-term economic turbulence in the UK, even in the eyes of Brexit supporters who think that it will benefit the country in the long-run. The second group: given the fall in oil and gas prices, “any company in the energy sector”.

In a sense there is no escaping from this market turmoil: all sectors are affected to a greater or lesser degree.

The prices private equity investors are prepared to pay for target companies are based largely on prices for similar companies in listed equity markets; no sector has been immune to the general fall in stock market.

Debt investors are also demanding higher yields across the board.

“We’ve done a couple of pharma deals in Europe over the last six months,” says Drake-Brockman, who notes that one of these was to a company sponsored by private equity. “The companies we lent to had very recession-proof profiles because they made cheap core generic products, which people buy whether in good or bad times. This isn’t discretionary spending.”

But even for this sector, he would demand a higher rate if lending now – even if only 0.5 percentage points more, rather than the full percentage point more which he thinks other lenders are demanding for weaker companies – “because risk factors have increased in the market in general”.

For market participants trying to work out likely mid-market deal volumes this year, a key question is how long this uncertainty will last.

“If there’s a vote to stay in the UK in June, we may see buy-side activity start to pick up,” says Donald Lowe, partner and private equity specialist in the finance team at Travers Smith, the City of London law firm.

He thinks that a ‘no’ to Brexit is likely to result in a broadly similar volume of European mid-market deals for the year as a whole, when compared with the numbers in 2015. Last year was regarded by participants as respectable though not spectacular, with a slight dip following strong activity in 2014. However, if there is a vote for Brexit, “all bets are off ”.

An uncertain environment reduces the volume of private equity deals largely because it leads to mismatches in price expectations.

“The recent volatility in the equity market has not been helpful,” says Maugüé. “Buyers are saying, ‘I’m not going to overpay for this asset when the relevant market may go down another 10 or 20 percent over the next few months.’ And sellers are taking time to adjust their expectations. As a result, I don’t see a lot of transactions at the moment.”

There is no firm data on average prices for mid-market transactions, but market watchers say that that multiples to EBITDA remain high by historical standards, with the multiples presently paid for some assets in the low double digits.

The investor relations specialist at the large European mid-market private equity firm says: “Finding a seller and a buyer that have exactly the same expectations is very hard. A buyer will want a discount because of all the volatility. A seller might not have adjusted their sense of a fair price because they’re still living in a different world.”

That being the world of only a few months ago, before dark clouds gathered over the global horizon.

The uncertainty is also a problem because it makes lenders less likely to accept high leverage. “Sponsors are getting about half a turn of leverage less, or somewhere in that ballpark,” says Maugüé. A sponsor that might have borrowed against a target company at six times EBITDA, for example, might now be able to borrow only at 5.5x.

“The difference may not seem enormous, but it can have a big impact on the internal rate of return,” adds Maugüé. This is because lower leverage forces funds to invest more equity to finance the acquisition of a target company.

The combination of lower leverage and high multiples is a deadly one for the private equity market, as funds generally try to make up for lower leverage by paying lower multiples.

The rise in yields on leveraged loans, as cited by Drake-Brockman, reduces the internal rate of return further. It has largely taken the form of increased up-front fees. 

Maugüé says he has heard of mid-market deals clearing with original issue discounts in the 95 to 96 range. The resulting four or five points of initial discount to the lender boosts the overall yield considerably. Meanwhile, the prevalence of higher yields has resulted in a quieter refinancing market, say market observers.

“For several years the interest rate environment was very good, so a lot of companies refinanced,” says Maugüé. For this reason, private equity funds are able to wait until rates fall again. “If the market improves later this year, refi activity will likely pick up very quickly,” he adds. But despite all the turbulence, private equity buying activity, and the debt issuance that accompanies it, are not completely closed.

DIRECT LENDERS

One reason why it remains open is the recent proliferation of direct lenders, which are often prepared to lend to companies sponsored by private equity on terms not acceptable to the banks.

“Sellers’ price expectations are high, so buyers need the leverage to make their returns stack up,” says Andrew Cleland- Bogle, London-based director at EQT Credit, the credit arm of private equity firm EQT Partners. “That’s where direct lending funds come into play, because they should be better at pricing the risk of higher leverage deals and therefore willing to take on these deals where appropriate than the banks, which are used to lowerrisk deals.”

There is also a strong sense among observers that the volume of mid-market deals could pick up very quickly, if the financial market volatility and geopolitical uncertainty ease.

One reason for this is the reasonable current levels of economic growth in most European countries, which contrasts with the more torrid time which European financial markets are undergoing. The European Central Bank forecasts eurozone output growth at 1.4 percent this year. Most economists expect UK growth to come in much higher, despite the Brexit turmoil: the Office for Budget Responsibility’s most recent forecast is 2 percent.

“The UK economic outlook is subject to many big unknowns, in the form of external shocks, but if you can put those to one side the underlying economic environment is not bad,” says Kevin Keck, partner at Phoenix Equity Partners, a London-based private equity firm specialising in UK mid-market deals. “Every year we look to make another few investments, and we hope that will be the case this year.”

Looking at likely market activity from the other direction, “we see our pipeline as very strong indeed at the moment”, says Anthony Fobel, London-based head of private debt of BlueBay Asset Management. He attributes this partly to “the relatively benign economic environment. Europe’s not seeing fast growth, but it’s not contracting either”.

He also cites a sense that “private equity firms are highly motivated to do deals”, because of the large amount of dry powder.

It is not just the private equity firms that are motivated to get the market moving again, says Lowe of Travers Smith. The debt funds are also eager for this to happen – possibly even more than the private equity firms, he argues.

This is because unlike general partners, who generally earn management fees even on their dry powder, the funds earn a return only on what they have lent. Lowe speaks of “tremendous fundraising on both sides: private equity houses and debt funds”. Lowe reckons there are “getting on for a hundred” direct lending funds in Europe, up from only about 30 to 40 a year ago. Direct lending funds tend to focus on midmarket deals.

Figures from PEI Research & Analytics show that Europe-focused mid-market funds raised $31 billion last year, the highest total since 2008, and this year is off to a robust start, with $5 billion raised between January 1 and March 14.

“There’s a lot of money out there not doing anything, both in private equity and in debt funds, so liquidity is not the issue,” says Lowe. The main obstacles are instead, he says, the “handbrakes” of high multiples and cash-rich trade buyers.

The comments by market watchers suggest that once the handbrakes are down, the mid-market juggernaut could move very fast indeed.