US leverage looking forward

What's the outlook for the US debt market in 2004? The answer depends on whether you ask a senior, mezzanine, or high yield debt provider. Alex J. Stockham reports up and down the financial structure about what these leveraged finance professionals are seeing and how they're feeling.

They say a rising tide lifts all boats. With the US economy making a strong comeback, as evidenced by the nation's gross domestic product growing at an annual rate of 7.2 percent in the third quarter of 2003, providers of all forms of debt typically used in leveraged buyouts are experiencing increased demand on their services.

But will 2004 be the banner year hoped for by senior lenders, mezzanine providers and high yield issuers, or will the three squeeze each other to the point where no one debt provider is able to develop much momentum? Lending professionals forecast a hotter LBO market in 2004, which would require increased financing, but they are also wary to repeat the mistakes made during the late 1990s and early 2000s, when too many unworthy companies were lavished with loans.

Mergers take capacity out of the market though we haven't seen a big squeeze

Senior lenders, such as those offering cashflow and asset-backed loans, have seen the multiples of EBITDA at which they are willing to loan capital make a meaningful shift upward, particularly over the past three to six months. At the beginning of 2003, senior lending multiples were approximately 2 to 2.5 times EBITDA, according to David Brackett, a managing director of Chicago-based Antares Capital. In the third quarter, he says, these multiples increased a quarterpoint and then increased another half-point over the past 90 days, making the current multiple for senior debt 2.5 to 3 times EBITDA.

The increased willingness to lend comes at a time when private equity firms are clearly in the mood to spend. “In the last 90 days, [private equity firms] have realised they have to find a home for their money,” Brackett says. “It's time to go out and get some volume.”

Despite the recent boom, however, the economy is not at the same level it was four or five years ago, meaning that although more deals are getting done now compared with 2001 or 2002, deal flow is still weaker than it was in 1999 and 2000. That means senior lending is in demand for certain types of private equity transactions, but less so for other, according to Ira Kreft, an executive vice president and group manager for Glastonbury, Connecticut based Fleet Capital.

At the same time, financings related to existing portfolio companies are abundant. The IPO market remains elusive for many private equity portfolio companies, but the need for liquidity is strong. This has led to an increase in recapitalisations and debt restructurings, which aim to pave the way toward a dividend or stock redemption. These give equity sponsors some liquidity but also allow them to retain a hold on their investment so that they still stand to benefit from a future sale of a company when the mergers and acquisition market becomes more robust.

“If there is some choppiness in earnings and less predictability, it may not be as good for us on the LBO side, but it can be good on the restructuring side,” Kreft observes.

Senior lenders who have diversified lines of business are finding this helps through economically rough patches, he says. And despite improving GDP data, the course of the economy can never be an absolute certainty.

The need for private equity funds to make new acquisitions has also fueled deal volume, as Brackett at Antares observes. Though the traditional mergers and acquisitions market is still depressed, private equity sponsor-to-sponsor transactions, or secondary buyouts, have partially filled the void. Brackett says approximately 35 percent of the deals his firm did in 2003 were related to sponsor-to-sponsor transactions, compared to 20 percent in 2002.

The last recession has built up a lot of scar tissue in people

Increased sponsor-tosponsor activity has affected mezzanine debt providers as well. Because of the pressure for buyout funds to show realised returns to their limited partners, as well as put new capital to work, deal flow in 2004 is expected to remain solid. And especially in the small- to middle-market, mezzanine debt has become an attractive option for equity sponsors, according to Muneer Satter, managing director and head of Chicago-based GS Mezzanine Partners, the mezzanine investment arm of financial services giant Goldman Sachs.

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GS Mezzanine Partners closed a $2.7 billion mezzanine fund last year. Approximately one-third of its current deal flow comes from the US with the remaining twothirds coming from Europe. “More deals are going to get done,” Satter says. “For our fund, it's shaping up to be an active year, especially on the Europe side.”

Transatlantic caution
Satter notes that mezzanine is used in larger transactions in Europe because of the relative lack of a high yield market in the region. European credits are also wary of taking on US dollar denominated high yield debt because of the currency risk. Because of the current strength of the euro, any slip would cause the value of the debt to increase significantly.

One concern for the mezzanine market in the US, however, is the fact that senior debt and high yield debt are becoming easier to secure as the economy rebounds. This can put a limit on the number of transactions a mezzanine firm can do despite the increase in private equity deals getting done, according to Terrel Bressler, the director of business development at Chicago-based Merit Capital Partners, formerly known as William Blair Mezzanine Capital Partners.

“If you think about mezzanine, we're in the middle and banks nip us from the top,” Bressler says. “Banks are doing more than three-times leverage deals, which takes away some of our opportunities.”

Not all mezzanine funds are concerned about a shrinking of deal flow due to increased bank lending, though. Thomas Knoff, a principal of New York Life Capital Partners with responsibility for mezzanine investments says that the increased spate of bank mergers will ultimately shrink the amount of capital available from senior lenders. After JP Morgan Chase's purchase of Bank One and Fleet Financial's proposed merger with Bank of America, less senior debt will be available, which opens opportunities for alternative forms of financing. “Ultimately, these [mergers] take capacity for senior bank loans out of the market,” Knoff says, “[though] we haven't seen a big squeeze.”

Other mezzanine specialists report continued demand for their product, despite the increased lending multiples for senior debt. Nicholas Dunphy, a managing partner of New York-based Canterbury Capital Partners, says: “All of the sponsors we know use mezzanine in almost all of their deals because they can't get the senior lenders to stretch as far as they would like.”

Scar tissue
The biggest story in the US debt market in 2003 was high yield, which practitioners say was on fire compared with previous years. It was the second best year in terms of performance since 1990, according to Mark Alter, a managing director of Washington DC-based private equity firm The Carlyle Group's US high yield investment fund. Most industry indexes had returns in the upper 20 percent range, he says. Because of that performance, 2004 looks to be a strong year for high yield debt in terms of attracting investment dollars. “People will chase that performance,” Alter says. “The space will have more cash to spend.”

As the high yield market has heated up, Alter says the asset class has become more speculative and EBITDA multiples have crept higher. This has led to the high yield community becoming a bit more speculative in terms of deals that can be financed.

If you think about mezzanine, we're in the middle and banks nip us from the top

About a year ago, high yield issue sizes tended to be $150 million or larger and companies would have to have EBITDA of more than $50 million to be eligible for high yield financing, Now, companies with EBITDA of as little as $25 million may be able to get high yield paper, Antares' Brackett says.

Brackett adds that solid companies with EBITDA north of $25 million may be able to secure high yield finance on multiples of between 4.5 and 4.75 times their earnings. “Lender quality is starting to be a bit eroded,” Alter says. “I think what is happening is you're seeing companies that we thought were overleveraged a yearand-a-half ago are now at better credit quality.”

Alter stresses that his firm and other high yield professionals will proceed with caution in 2004. “We're trying to be a bit more cautious because there's not all that much relative value in the marketplace. And we don't need to put money to work.”

While the improving US economy has brought more appetite for risk to debt financing for private equity transactions, all parties involved are loathe to repeat the mistakes made in the late 1990s, when leverage was heaped on companies without realistic business outlooks. Caution remains the mood of the day. Loans will be made based less on a hope of what will happen going forward, and more on a confidence for how a company has performed in the past.

“I don't see people willing to be more risky this year,” Merit Capital's Bressler says. “The last recession has built up a lot of scar tissue in people. For greater cashflow generating companies, those will be the higher multiple deals.”

Brackett adds that the marketplace has been at similar points in the cycle before, for instance during the credit crunch in 1991 and 1992 which dissipated with the resurgence of the high yield market in 1994. Now, almost exactly 10 years later, the same scenario is playing out, many believe. Says Brackett: “History has a funny way of repeating itself.”