Strangers in the structure

In April, Private Equity International gathered together a group of leading European private equity professionals to reflect on deepening liquidity in the leveraged finance market. The rise of the institutional investor was a major talking point, reports Andy Thomson.

Rather like the view from atop London's 30 St Mary Axe building – popularly known as “The Gherkin” – current conditions in Europe's leveraged finance arena might be described as exhilarating. With sponsor demand for ever larger and faster slabs of debt funding, combining with a febrile clamour on the part of investors to feed this growing appetite, it seemed to us an apposite time to gather a selection of Europe's leveraged luminaries together to survey the Gherkin's impressive panorama and provide some cool reflection on an apparently red-hot market.

Whether for better or worse – and there are plenty who will argue it either way – one proposition that draws a broad consensus is that there has been a fundamental and dramatic deepening of liquidity in the European debt market in recent times. Said John Kelting, managing director of leveraged finance at Barclays Capital: “Two years ago, a €10 billion financing could not be done. With the explosive growth of CDOs and hedge funds active in the leverage markets and with appetite from cross-over investors and existing market players looking to increase their exposure across a broad spectrum of risk/return in leveraged deals, this size of transaction can now be readily executed.”

This, together with the megafundraising spree of the past two years, has enabled LBO houses to pursue assets that not so long ago would have been well beyond their reach. The trend has thus far shown little sign of slowing in 2006, evidenced by deals such as the €10 billion buyout of Danish telecom TDC and the pending (highly controversial) €7.4 billion offer for Dutch business information group VNU. Such deals have one obvious trait in common: they demand outsized loan packages. And, with investors searching aggressively for yield in a low interest rate environment, that demand is being eagerly met.

Symbolic of the larger and more sophisticated capital structure of today is the emergence of the second lien market, which provides capital that sits in between the senior debt and mezzanine tranches. The value of such loans in Europe rose to just over €5 billion in 2005, compared with €1.5 billion in 2004. For sponsors, second lien has obvious attractions in a highly competitive environment – for one thing, it tends to be cheaper than traditional mezzanine and other forms of subordinated debt, including high yield. The fact that it does not carry warrants and can be repaid at par without penalty also adds to its appeal.

But there are dangers. Amid the embrace of second lien (and the concomitant squeezing of the traditional mezzanine layer), long-established relationships are frequently being swapped for new and untested ones. In the case of second lien, the hungriest consumers by far are institutional investors, whose impact on the European leveraged loan scene has been startlingly swift. According to figures from Standard & Poor's, such organisations accounted for just four percent of European leveraged loan market value in 1999 – rising to 37 percent by the end of 2005.

One question faced by sponsor groups today – and which some may prefer to delay answering definitively until a later date – is whether they are comfortable with these new entrants. Hugh Briggs, a director at pan- European buyout firm CVC Capital Partners, responded that any concerns about deal partners can be effectively dealt with by a little old fashioned investigative work. “The type of investor – whether it's a hedge fund or a CDO fund, for example – is irrelevant,” he contended. “But you must try to work out their motives, how long they've been in the market, and how they've behaved during industry cycles.” Adding a cautionary note, he said: “You don't just agree to bring someone on board because they're writing the biggest cheque.”

The main reason for thinking twice about who you invite into a deal is how they will behave once they're there. In the US – where institutional investors account for around 80 percent of the leveraged loan market – things have not always run smoothly. Take, for example, the ongoing bankruptcy proceedings at California power company Calpine. A source close to the hearings told Investment Dealers Digest that the company's second lien lenders, in particular those representing hedge funds, “were determined to play hardball” and “seemed interested in maximising their recoveries, regardless of the implications on Calpine's long-term viability”. European LBO protagonists might feasibly worry about such a scenario unfolding on this side of the Atlantic.

On the other hand, there is recognition that institutional investors must not be viewed as a homogenous group. “Some are just traders, while others have serious long-term attitudes – even within the hedge fund community,” suggested Phillip Burns, a financial managing director at London-based buyout firm Terra Firma Capital Partners.

Added Briggs: “Most institutional investors are CDOs affiliated to, or spun off from, banks or long-term money managers like Pramerica or Eaton Vance. Only a small number are hedge funds. These “new” institutions are often populated by people with long track records in leveraged finance.”

Katharine Belsham, a member of the UK and Ireland investment team at London-listed debt provider, Intermediate Capital Group, argued that her firm is one example of an outfit that has long played in different parts of the capital structure – and can be a trusted partner because of this. “We launched Europe's first CDO fund in 1999 because we wanted to access high yield as well as mezzanine,” she said. “We're holders of assets, and we want big positions in syndicates.”

In any case, sponsors do not lack influence when it comes to the construction of syndicates – essentially, they still have the power to choose the group of providers they want. Says Charles Barter, head of private equity at London-based law firm Travers Smith: “You must know where the paper is going and have good relationships with those people. It's better to set up a syndicate on the basis of dealing with people that you know.”

On the other hand, too rigorous an analysis of potential syndicatees would prove time-consuming and expensive: a potentially prohibitive handicap in an environment where speed of execution is such a key determinant of success or otherwise in the now-ubiquitous auction process.

Such considerations are significant. Consider that the motives of sponsors and lead banks may be very different when it comes to drawing up the syndicate guest list. For example, from a banking point of view, hedge funds represent a potentially lucrative client base that requires careful nurturing. Says Kelting: “Barclays Capital does a lot of business with hedge/credit funds across its different businesses and they are an important investor base for the firm. They are keen to buy leveraged paper, and we have to marry that demand with the type of syndicates private equity firms want to see. As part of this process we work closely with private equity firms on explaining the investment strategies of the leading funds, and their long-term interest in the leveraged market.”

The latter point is important, because, in an ideal world, sponsors would probably rather not want to get hedge funds involved in debt syndicates at all. As one leading GP recently opined to PEI: “When we're in competition with them for deals, hedge funds have a different cost of capital so they drive prices up; they boost debt liquidity but make the market frothy in the process; and they can make our life difficult when we're bidding for public companies.” In a nutshell, private equity investors and hedge funds don't always see eye to eye.

The two camps may have to find a way of rubbing along together nonetheless. One message that emerges from the roundtable is that the expansion and diversification of the leveraged investor base is irrevocable – at least for the foreseeable future. Nowhere is this reality more evident than in the diminishing amount of debt that lead arrangers are prepared to retain on their balance sheets. At a recent industry gathering in Oxford, it was noted that a decade ago, around 85 percent of total debt in an average large European buyout was kept on the lead arranger's books. Now, that figure is estimated to have skydived to around 15 percent.

Of course, these numbers require context. Given the exponential increase in the size of buyouts over that period, 85 percent of a 1996 deal may in many cases represent a rather smaller sum total than 15 percent of a 2006 transaction. However, there was broad acknowledgment at the PEI roundtable that lead arrangers are now essentially sellers rather than holders of positions. “For the largest deals, while credit remains the major focus, distribution strategy and capability is increasingly key for arranging banks,” confirmed Kelting.

He went on to relate how Barclays Capital has had to become adept at selling different kinds of investment case to the secondary banking market. To sell positions in UK motor insurance firm the AA, which underwent a £1.8 billion buyout in July 2004, Barclays focused primarily on the track record of the management team, on the basis that it was aiming to reproduce a strategy it had already successfully executed at rival firm Kwik-Fit (many of the banks and investors Barclays pitched to had been involved in that prior deal). In the case of Luxembourg-based satellite operator SBS, which was bought for €1.9 billion in August last year, the sales pitch, by contrast, centred primarily on the strengths of the industry sector.

At the very large end, debt has become a distribution business. Only at the smaller end is it still more about credit analysis

Whatever the sales message, the fact is that an unprecedented volume of debt is currently being sold on. In the case of a €3 billion recapitalisation at UK chemicals business Ineos Group earlier this year, a total of over 200 entities participated in some way or another in the financing, according to sources. An investor base of that magnitude must surely raise question marks over the quality of the relationships between the various parties. Even keeping tabs on the identity of these groups – quite aside from the point made earlier about their motives – is a demanding task, particularly given the increasing trend for short-term investors to quickly offload positions to others. One common sponsor fear is that such investors will sell out to distressed specialists at the first sign of trouble rather than participate in a workout.

One important means of protection against rogue behaviour from investors lies in the documentation drawn up by lawyers in order to govern how syndicates operate. “There is documentary protection,” insisted Barter. “You can, for example, “yank the bank”, i.e., if there's a troublemaker, the company will have the right, in certain circumstances, to arrange for that person to be repaid or to require it to sell to someone else.”

In addition, the degree of power wielded by second lien investors in Europe tends to be restricted by documentation that will not normally rank their debt claims equally with those of senior lenders (unlike in the US, where second lien loans tend to be neither structurally nor contractually subordinated to senior debt). In addition, in the absence of Chapter 11- style protection, European deals normally include standstill provisions on enforcement action being taken by second lien holders – leaving senior parties in control of any enforcement procedure.

However, despite such precautions, the roundtable guests expressed apprehension as to what might happen to some syndicates should trading conditions unexpectedly take a turn for the worse. In particular, they share a concern about certain European countries where megadeals have begun to take root but where the legal jurisdictions may fail to afford adequate protection to investors.

“In the UK, because of the legal framework, banks are given priority – but in some European countries supplier, employee and shareholder rights all come before those of the banks,” said Briggs. “With a bankruptcy in France, the banks will definitely end up getting less back than they would elsewhere in Europe.” Despite this, Briggs and others around the table took the view that this increased level of risk is very rarely priced into deals.

Perhaps counter-intuitively, there was some desire expressed for a couple of major sponsor-backed bankruptcies to happen in Europe, so that people would then have a greater understanding of how the process would unravel. Such a hope, of course, is based on the assumption that it will befall someone else! But there was also a belief expressed around the table that no such fallouts are on the immediate horizon, given an exceptionally low default environment.

“It's hard to see where defaults will come from,” said Belsham. “There have been a very low number recently and there is a lot that the equity provider can do to try and stop them from happening. You would need severe under-performance for defaults to become a trend.” In the UK at least, such a rapid decline in economic fortunes is unforeseeable, although in other parts of Europe the climate is arguably a little more volatile. Belsham added that ICG would walk away from deals “when the price no longer reflects the risk”.

But even if there's little fear of a meltdown, there is a strong sense that now is a time to be exercising caution amid intense competition for deals. “You need patience and discipline because prices are stratospheric,” said Burns. “Good businesses are getting tougher to find and it's getting harder to justify the prices paid for those businesses.”

Briggs agreed that life has become tougher. In his mind, in terms of the default rate, the industry is still benefiting from deals struck in the pre- 2004 period when multiples remained relatively low. But given the increasing amounts of leverage that have been shoehorned into deals since then, coupled with the prospect of higher interest rates, Briggs believes that operational skills are being tested to the limit: only through the ability to implement additive strategies such as restructurings and add-on acquisition programmes can decent returns be delivered in today's climate.

In sum, it's tense and tough out there in the European leveraged finance world, and more than a few nervous glances are being cast in the direction of unwieldy syndicates. People know there's a potential problem looming, and they know it needs confronting. “If you're pushing the leverage so much on a deal that you need to overly worry about what the syndicate looks like, then perhaps you should take a step back and consider whether you are, in fact, overleveraged,” suggested Burns. In such a liquid market, this is a home truth that's disturbingly easy to ignore.


Head of private equity

Travers Smith

Barter trained at London-based law firm Travers Smith and became a partner in the corporate department in 1995 after a year on secondment to a New York law firm. He co-founded the firm's private equity group in 1996 and has specialised in private equity work ever since. Now head of the private equity group, he advises institutional investors, management teams and a significant number of private companies. In 2004/05, he advised on the buyouts of Tunstall Group; Tussauds Group; Cas Services, Pets at Home, Saga and Lego.



Intermediate Capital Group

A graduate of Durham University, Belsham joined London-listed ICG in 1999 from NatWest bank, where she was a manager in the acquisition finance department. Previously, she had worked in the corporate banking division of Lloyds TSB. A member of a team of directors covering the UK and Irish markets, Belsham has been involved in buyouts including Target Express, Pets at Home, Tunstall Group, Thornbury, Welzorg, Jane Norman and TeamSystem.



CVC Capital Partners

Now a director in the international team based in London, Briggs joined pan-European buyout firm CVC in 2004 from MidOcean Partners (formerly DB Capital), where he worked on deals including the sale of Center Parcs UK to Abor for £285 million in December 2003 and the sale of Laurel Pub Company's managed pub division to Greene King for £654 million in August 2004. Prior to joining MidOcean, he spent five years in leveraged finance at Citigroup and CSFB.

Phillip Burns

Financial managing director

Terra Firma Capital Partners

Burns joined London-based Terra Firma in 2002 and has since worked on buyouts at Waste Recycling Group and Shanks, and was also notably responsible for portfolio company Deutsche Annington's €7 billion acquisition and financing of German property group Viterra in May 2005. Burns began his career as an M&A attorney with Skadden, Arps, Slate, Meagher & Flom, before going on to join Goldman Sachs in 1998, where he subsequently became a vice president in investment banking.


Managing director

Barclays Capital

Kelting joined Barclays Capital in 1998 to help develop its leveraged finance business, and is its joint head of private equity origination. He previously held positions with a number of debt and equity institutions, having started his career with HSBC in Hong Kong, where he was an international officer for four years. Recent leveraged deals in which he has led the debt financing include SBS, KwikFit, Petroplus, AA, Springer, Kluwer, Halfords and Bourne Leisure.