What's up in leveraged?

Up to 80 per cent of the economic capital put into an LBO doesn't come from private equity funds: it is provided by banks as debt. Given the pivotal role leverage has to play, what's the present state of the leveraged finance market? Robin Burnett reports.

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 (LBOs) 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, Director of Loan Syndications Origination 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, Co-head of Global 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 as the accompanying chart shows.

?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, Managing Director of Global Leveraged Finance 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, something Collins at Merrills confirms: ?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 ?LBOfriendly? 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.

Deals are 20 per cent less aggressive than the same time last year

?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 [there] 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 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 £200 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. ?Different industries have different cyclical characteristics and therefore require different financing structures?, points out Stuart Fleet of SEB Acquisition Finance, underlining this point.

The buyers
Historically, banks provided the vast majority of senior loans, even those that were syndicated outside of an arranger group. Mezzanine, if any, was typically provided by one of a small number of specialists, such as Intermediate Capital Group or Mezzanine Management. With the introduction of high yield bonds into deal structures in Europe from around 1997 came a new group of investors, latterly insurers or other institutional fund managers looking for yield, though originally those that had already dipped their toes into other alternative asset classes such as distressed debt.

Activity is likely to pick up in the first half of 2002

More recently, such investors have begun to diversify into senior loans and mezzanine and the institutional investor segment itself has broadened and evolved as specialist LBO/high yield debt managers have begun to emerge. ?There's much more appetite now from nonbank investors. They have fewer hang-ups, problems or constraints to lending?, says a syndication professional. Indeed, for van Rijn the ?coming up to speed ? big time? of such investors is a key recent trend in the LBO debt market, and, if the US market is anything to go by, they will proliferate rapidly.

The principle reason for the attractions of the market to all concerned are of course the returns offered, with typical senior loans offering from 2 to 3.5 per cent over cost of funds at the moment and high yield bonds, though much more volatile, still offering close to double digit yields.

What's next?
?There has been a polarisation amongst venture capitalists: there are those who are not going to do anything much until next year, but there are others who are saying ?let's look for bargains??, says Hamilton at RBS. ?There are some sponsors who are, no doubt, concentrating on parts of their existing portfolio,? adds Fleet. Most providers of debt finance do agree that there seems to have been a ?flight to quality? since September 11. ?Quality in this market is perceived to be the larger deals,? says van Rijn. The effect on transaction prices and the acquisition/ disposal process does appear to be mixed thus far, however, as opinions are divided. ?There is a discrepancy between vendors and the private equity houses in terms of price expectations?, says van Rijn, pointing to recent examples such as the collapse of the buyout of WHSmith's news distribution business.

Conversely, ?vendor expectations have moved on ? there are still deals to be done?, declares Hamilton. Indeed, such opposing views were widespread among those interviewed ? perhaps in part reflecting the short period of time that has passed since the events of September 11. Kelting at Barclays Capital offers a potential explanation here: ?There is a lot of uncertainty on what the value of a business should be at the moment due to the outlook for earnings and the future uncertainty of public equity markets.?

The effects of the increased uncertainty are also reflected amongst those arranging debt finance. ?It is still possible to get comfortable with credit risk, but not necessarily with underwriting risk?, says one senior manager at a leading underwriter. ?You don't want to do the second best deal in a particular industry sector.? ?Deals with a large US component are looked on negatively now; the same is true with high growth companies?, adds a peer. ?Lots of deals are going onto the back burner.?

Market flex
When syndicating a deal, arrangers are also faced with a less predictable outcome. Banks are putting proposals forward, but do not always know how their credit committees are going to react. This is causing the often controversial issue of ?market flex? to come to the fore once again. This is where the arranger can revisit the terms of the financing in light of the market's reaction to it, be it positive or negative. ?There are loads of deals being flexed now?, notes van Rijn. ?There are some difficult discussions going on between banks and sponsors regarding deals which have not syndicated?, adds Kelting.

?Market flex has come to the fore?

Though most people are reluctant to discuss market flex in specific terms, examples such as the acquisition of Britax by Royal Bank Private Equity, which at the time of this issue going to print had yet to emerge in the debt market, were widely referred to. Inevitably, as it has before, this will lead to the disappearance of some market participants and what Kelting also describes as a flight to quality of a different sort ?as sponsors focus on their core relationship banks.?

In general however, people's views largely echo that of Hamilton at Royal Bank of Scotland, who characterised his institution's approach as ?cautious, but supportive.? ?The pipeline is not as full now as we would like to see it,? comments van Rijn, also a common sentiment. Significantly though, all pointed to the first half of 2002 as the period during which activity is likely to pick up.

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