The refinancing race

Can the debt markets handle the $800bn of outstanding LBO loans?

It is difficult to assess the condition of the debt market today. Companies that raised acquisition finance for MBO transactions during the high-liquidity boom period of 2003-07 are now faced with the prospect of refinancing their loans as they reach maturity. Yet this is becoming increasingly challenging at a time when banks have either tightened their criteria or withdrawn from the market completely.

On the other hand, given the return to more conservative, traditional lending models in the post-crisis era, those companies that have sound business models are finding banks more than willing to lend. These factors have created a division within the LBO market.

But just how much of an issue is the lack of refinancing debt, and how readily available is new loan financing?

The Wall of refinancing

According to a report published by law firm Freshfields Bruckhaus Deringer, global private equity-backed LBO transactions will require more than $800 billion of refinancing over the next five years, across approximately 6,000 deals.

In Europe alone it has been estimated that there is some €375 to €400 billion of amortising debt that will need to be repaid to the lending institution before 2017. Broken down by maturity, the scheduled amortisation of these loans for 2010 is some €10 billion, a figure rising to €16 billion in 2011, before reaching €96 billion by 2014.

There are several reasons why this wall of refinancing should have formed. Back in 2007, with high liquidity, banking practices were somewhat different from those today. At peak lending levels, average EBITDA multiples stood in the region of 6x, although some deals were funded on as much as 11x EBITDA. And for private equity-backed transactions, the debt-to-equity ratio could be as high as 80:20.

Then came the credit crunch. Mark Vickers, partner in the finance department of law firm Ashurst, explains: “As a result of over-leverage in the period leading up to 2007, when the credit crisis hit in 2008 many banks sought to dispose of those assets that were most vulnerable. However, as there were few buyers, they instead implemented an ‘extend and amend’ strategy, temporarily refinancing the loan in the hope that economic conditions would improve. But as the crisis led to a long-term downturn, those businesses that were reprieved in 2009 will still need refinance in 2013-14.”

Michael Grayer, head of Lazard’s UK debt advisory, agrees: “Whereas the majority of investment-grade debt is being actively refinanced by the rejuvenated high-yield bond market, there still remains a large portion of sub-investment grade debt that is reaching maturity. Furthermore, whereas CLOs has been in parts responsible for driving liquidity in 2003-07, the fact that since then there have been few new issuances is also a compounding factor, as they could offer a solution.”

But despite the seriousness of the coming squeeze, some industry experts believe the problem is overstated.
Appu Mundassery is a managing director of Bayside Capital. Like Lazard’s Grayer, he sees strong investor appetite for non-investment grade paper as a reason to be optimistic. He says: “In Europe, the so-called ‘wall’ will be amply catered for by high yield. And, with the maturity of the bulk of the debt due to peak in 2014, there is time yet for the market to find ways of managing the remainder.”

But clearly not every deal will be steered to safety. Vickers warns: “We have not seen anywhere near the number of casualties yet. There still remains a pressing need for many banks to reduce their balance sheets and as the companies that the banks want to divest will naturally be the worst-performing ones in their portfolios, refinancing will be a difficult and unattractive option. Therefore they will most likely opt to sell these for a discounted price and simply put the loss down to experience.”

New deals

When it comes to new buyout activity, the picture looks very different and healthier. In the US last year, according to ratings agency Standard & Poor’s, approximately $35.4 billion of loans were arranged for large and mid-cap private equity transactions. Whereas this is nowhere near the $189 billion of funding seen in 2007 when the market peaked, it is nonetheless a dramatic rise from the $5.3 billion recorded in 2009, and marks a return to form for the US LBO market.

Meanwhile, across the pond, Bloomberg data reports that there was just over $16 billion LBO loans across Europe in 2010, with some analysts expecting this to rise to as much as $46 billion for the current year.

Despite this apparent rise in liquidity, there are a number of factors that will determine where the money goes.
In the wake of the crisis there has been a wholesale shift towards sounder banking practices. Vickers says: “In the new world order, and following the recommendations set out in Basel III, lending multiples have plummeted to a very conservative average of 4x EBITDA and private equity deals are structured with a more balanced debt-to-equity ratio.”

Whilst this is a welcome development, it nonetheless makes the selection process for companies more stringent.
“The ability to secure new funding will depend on the market segment and the individual performance of the company,” says Jonathan Broome, head of the UK debt advisory team at  mid-market investment bank Lincoln International. “Separately, if the company has the ability to raise more than £100 million of drawn debt then it will likely be able to secure new funding on better terms due to additional liquidity in this segment of the market place.

However, if it has the ability to raise less than £100 million of drawn debt the likelihood of securing funding will depend on the performance of the company. If performance is right in the middle of the fairway then it will be fine, but if it is in the rough then it may have to look to alternative forms of financing.”

There is also a disparity between the US and the European markets. Broome continues: “In the UK mid-market, a number of foreign lenders have returned to their home regions. Today, the UK mid-market is left with a relatively small pool of banks. In such circumstances, when raising debt facilities of less than £100 million club deals are likely the only way to source LBO funding, but these can be more difficult to arrange and can take longer to execute.”

Examples of banks that have left include Dresdner, West LB, Fortis, CIT, Dresdner, as well as the Icelandic banks.
Lazard’s Grayer sees a new dynamic. “In the US we are seeing many asset managers raising new CLOs, which will prove a key source of acquisition financing.” Groups that launched CLOs in 2010 included Ares Management, M&G Investments and Haymarket Financial.

Mundassery at Bayside believes that there are more options than traditional investment banking. “Today companies may need to look beyond the banks. For example, in the US, [Business Development Companies] and primary funds are providing alternative sources of funds and are providing competition to banks. This is because there are many good mid-market companies that require capital but have found themselves under-served by the traditional banking model.”