When dealing with their bankers, LBO firms are calling the shots – for now

The 2005 buyout season is underway, and much continues to go right for Europe's private equity elite, especially for the firms that invest in the biggest deals.

Last year European buyout GPs sold more of their investments than ever before, either to each other or to other types of buyers, and generated very welcome distributions to investors in the process. And in terms of new acquisitions, Europe for the first time outstripped deal activity levels by value compared to the US, according to data compiled by Thomson Financial.

Better still, the waves of institutional capital that made last year's dealfest possible are still rolling into the leveraged finance market, as investors continue their hungry search for yield further out along the capital structure. Investment bankers lament that try as they might, they just cannot supply enough product to satisfy all those eager investors in the queue. Must be tough.

Have a look at the European high yield market and you soon get the point. A record €27 billion worth of sub-investment grade bonds were sold last year, up more than €8 billion on 2003. But as far as the buy side was concerned, this was not enough: by the end of the year, spreads were as tight as any that this market has experienced.

“There is demand every way you turn, and I don't know what will make it stop”, said Katherine McCormick, the head of credit research at JP Morgan, at a January gathering hosted by the European High Yield Association (EHYA) in London. Might there not be a sell-off that would calm the buy side any time soon? McCormick and her fellow panellists said they couldn't see that.

Amid the frenzy, equity sponsors could be forgiven for getting used to having things their way. In their dealings with the investment banks in particular, private equity firms can leverage (sic) a probably unprecedented position of strength. Here are a handful of observations to support the assertion that private equity pros are brimful of confidence at present.

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Last year BC Partners was able to recoup 93 percent of its investment in Tele Columbus, the German cable company, without diluting its equity interest and just nine months after buying the business. And this was no one-off: other sponsors have done similar transactions.

Our terms or no terms
Speaking at a PEI conference in New York last November, a senior London-based deal professional at one of Europe's largest buyout houses told delegates that lately his firm had taken to sending out term sheets to banks eager to help fund the firm's purchases – rather than the other way around as is the norm in less frenetic markets.

Who dares wins
A transaction lawyer advising London-based LBO houses told me recently that one of his clients, whose name he didn't reveal, had succeeded in persuading the bank that provided the senior debt for one of its acquisitions to agree to the following: in the event that the company would sell shares in an IPO, the bank would leave its money in the structure until after everyone else, including the subordinated debt and the equity, had cashed out. “It was almost like they were curious to see whether they would get away with this, and lo and behold they did!” marvelled the lawyer, adding he had never before seen a bank accept such a clause.

Get out of our yard
After losing out to a consortium led by DLJ Merchant Banking, the captive principal investment business owned by Credit Suisse First Boston, in the hotly contested auction for Northern Ireland's Warner Chilcott, a number of livid private equity chiefs reportedly picked up the phone to CSFB chief executive Brady Dougan to tell him how they felt about it. “We're paying you a bunch of fees and your guys go and poach our deals!?” was the gist. Shortly thereafter CSFB took steps to appease its private equity advisory clients and protect its income stream from the industry: in December the bank announced that the conflict-prone buyout operation would be spun off.

The power to influence strategy at a major investment bank didn't use to be associated with private equity. And as long as the industry continues to dominate international M&A, it will likely remain able to call shots of this kind.

But taking this level of influence for granted would be dangerous. There will come a time when the markets will obsess much less about the industry than they do now. At that point, friends retained in banking circles will count for a great deal.