What’s up in Leveraged?

The availability of appropriate debt financing (in terms of size, structure and price) in a leveraged transaction is the difference between a deal’s success or failure. It comes as no surprise therefore that private equity firms specialising in leveraged buyouts have been busy talking to the banks to ensure that their plans can be executed in a market that many regard as becoming tighter and tighter as banks get increasingly cautious in their lending.

A growing market?

The majority of LBO debt financing is provided in the form of loans to the acquiring entity. It is no surprise, therefore, that lending volumes have increased as the amount of funds under the management of the private equity community has grown. Indeed, the first half of 2001 was “without doubt the best ever in my experience” according to Arjan van Rijn at Deutsche Bank.

The second half of this year is predicted to show a very different picture, with volumes significantly down, though activity has definitely not stopped entirely. “People have decided we’ve just got to get on with life … we certainly haven’t shut the door here” comments Euan Hamilton, joint head of leveraged finance at Royal Bank of Scotland.

So does increasing amounts of money to spend mean more deals are getting done? Mostly, yes, though it’s a matter of actually winning deals too, as more and more vendors hold auctions to get the best terms. However, private equity funds are clearly able and ready to chase down deals. “Financial sponsors have proved themselves capable of outbidding trade buyers”, says Matthew Collins, managing director of leveraged finance at Merrill Lynch. Tellingly though, it appears that purchase prices have not actually gone up.

If purchase prices are not rising, are deal structures becoming more conservative with a higher amount of equity in them? This too does not necessarily seem the case either.

“Equity levels have remained relatively flat”, says van Rijn at Deutsche. Though the trend towards more conservative structuring appears slight but progressive, this may have accelerated post-September 11. “The debt market has seen multiples decline since September 11,” says John Kelting at Barclays Capital. “This is partly explained by banks running harsher sensitivity cases, resulting in less cash flow available to service debt.“

“Leverage has come down, especially total” says van Rijn. Collins at Merrills: “Deals are 20 per cent less aggressive, as a rule of thumb, than the same time last year”. These changes to leveraged structures may well impact private equity fund returns – although this will only become apparent over time. Returns are ultimately a function of exit as well as entry terms, though logic would suggest that a lower entry level combined with a more conservative deal structure should at least result in fewer failures if not better returns.

Widespread activity

It has been said in the past that some industry sectors simply do not support leverage – a situation complicated in Europe by significant differences between jurisdictions and how creditor or “LBO-friendly” they are. “In a difficult sector, leverage will be below average. For the ‘right’ deal, leverage can be taken above average”, says one head of loan syndication in London, citing telephone directories business Yell as an example of the latter.

“This will always be an opportunistic market, which tends to produce deals in seams” says Collins. The chemical sector, which is undergoing a global restructuring as various players seek to exit from or consolidate particular sub-segments, is one current example, and one cited by all those interviewed for this article. The sector has seen, by number of deals, one of the highest levels of issuance for 2000 and the first half of 2001, according to S&P/Portfolio Management Data. Among other specific sectors, the building materials and entertainment and leisure sectors are close behind, though the broad categories of manufacturing and services continue to see the highest numbers of leveraged deals.

There is also an increasing geographic diversity to deals. “The private equity market in each country is driven by different things; in the UK, the public equity market; in Germany, the restructuring [of industrial holdings]” says Collins. Germany, though, has been a market of mixed success prior to this year; “it has been less dramatic than everybody expected. There is so much more potential still”, says van Rijn.


The main players and their instruments

Although there are an increasing number of debt instruments used to fund LBOs, the trend of the past few years has been clear: to compete effectively, particularly in relation to larger transactions, a banker has to have a range of capabilities. “Nine out of ten sponsors ask for alternative capital structures including senior, high yield and mezzanine to be presented. They want you to set out options so that they can choose, depending upon their strategy” says van Rijn.

This has levelled the playing field somewhat for US investment banks such as Merrill Lynch, Morgan Stanley and Goldman Sachs, which all utilised their fixed income expertise as a way into the market. Now it’s the turn of the “traditional” market participants such as Bank of Scotland and Royal Bank of Scotland, who have significant lending capacity but were lacking in fixed income distribution ability: all have sought to round out their capabilities in order to service sponsors’ requirements.

Nevertheless, a mature European high yield bond market has yet to develop. “Some sponsors are more receptive than others to structures with high yield in them, though even the non-receptive have done deals with a high yield bond issue in order to get the debt multiple they wanted” says van Rijn. However, “high yield is not a panacea” says Collins. “There’s a lot more healthy debate and analysis on the right way to finance a transaction” with “a more complex basket of products offered today.”

As a result, mezzanine finance has made something of a comeback. The limiting factor of the traditional mezzanine market was its depth. Today the mezzanine market is much deeper and can often be used to replace a high yield issue. “You can certainly get £200m to £300m away in mezz now – the market has really stepped up”, says one banker.

The leveraged market today seems to be less about competing forms of finance and more about a range of options that can be offered to meet sponsors’ needs and those of the transaction.

By Robin Burnett

The above is an extract from What’s up in Leveraged?, which was published in the December issue of Private Equity International, our buyside-focused private equity magazine.

Robin Burnett is a training consultant at BG Training and works as a freelance writer. He worked in the European leveraged finance market on both the buy and sell side for nearly 10 years.