The ones that didn’t get away
IT CAN’T BE often that Henry Kravis, co-founder of Kravis Kohlberg Roberts, has to eat his words. But that is something that he might soon be forced to do if the leveraged loan market does not quickly recover from a bad case of the frights it caught during June. Just one month earlier, in May, Kravis had described market conditions as a "golden era" for buyouts. In June, though, financing packages that had been put together for several of his firm’s deals were facing emergency restructuring or even complete postponement in the loan market. By July, the $18 billion loan financing for KKR’s acquisition of UK firm Alliance Boots had been pulled as investors balked at the aggressive, covenant-lite terms. It is not Kravis but his banks that are faced with this problem – and that means that for sponsors such as KKR, the golden era could already be over.
The double-digit leverage multiples and aggressive debt financing packages that have characterized the LBO market for some time have led even the most casual observer to conclude that some sort of correction must come. And come it has, with a series of transactions being either restructured or shelved altogether as a result of investor pushback (see The ones that didn’t get away). There is little disagreement that this is a good thing for this market, a much-needed sell-off in response to overly aggressive deal terms. But the same question lurks in the back of everyone’s mind: rather than a necessary market normalization, could this be the beginning of something far more serious?
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"There is the potential for a significant correction this year"
Jim Amine, Credit Suisse |
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Even those who are optimistic that what we have recently witnessed is a temporary sell-off are very aware of the fragility of this market. "There is the potential for a significant correction this year," warns Jim Amine, managing director and co-head of global leveraged finance at Credit Suisse. "The amount of liquidity could decrease materially." But there are now so many factors bearing down on the loan market that it is almost impossible to tell which way things will go. "There is something fundamental happening here," says Matthew Prest, managing director at Close Brothers. "But whether or not it signifies the beginning of a credit crunch we simply can’t foresee."
Be afraid, be very afraid
The timing of the current retrenchment could not have been worse for LBO sponsors. Mid-year, there was a $250 billion pipeline of new deals in the US alone. Enormous deals were waiting in the wings just as the market was experiencing some serious jitters. The $26 billion takeover of First Data by KKR was to have involved a $16 billion loan and $8 billion tranches in a deal to be arranged by Credit Suisse. KKR, together with Texas Pacific and Goldman Sachs, is also behind the $37.2 billion buyout of TXU – a deal that is expected to involve a $25.9 billion term loan and $11.3 billion bridge loan financing.
Borrowers such as this are hugely reliant on non-bank investors – who now buy 82% of lending in the US. How these buyers react to the next few high-profile deals will to a large extent dictate just how bad things are going to get. Neither lenders nor borrowers can afford for there to be any sort of investor strike, and the last thing either side needs is another large, very public transaction to go wrong. "It doesn’t take too many more of these situations to get people very worried," says a leveraged finance banker. "Nothing focuses the mind like having to take bridge financing on to your balance sheet."
And nothing demonstrates how nervous the European market had become more than KKR’s bid for Alliance Boots. All eyes were on the £9.02 billion loan to back KKR’s acquisition, the largest leveraged loan buyout in Europe. This was not able to refinance, leaving the bridge in place. Arranged by Bank of America, Barclays Capital, Citi, Deutsche Bank, JPMorgan, Merrill Lynch, RBS and UniCredit, the deal had long been expected to come with covenant-lite documentation. When the deal was launched in early July, however, market conditions had changed. As well as expanding the margins on many of the loan’s tranches, arrangers were forced to offer the market an upward flex on the deal’s interest margin. Two of the bookrunners also committed themselves to stabilizing the deal at par in the secondary market. A financial requirement of this magnitude for what is not a blue-chip retailer will inevitably raise questions about prudent debt multiples.
From the investor perspective the situation is straightforward: sponsors have abused the imbalance between demand and supply to push inappropriately aggressive deal structures and are now getting punished for it. "What has happened is a positive development," says William Healey, chief executive at Picus Capital Management in London. "Investors are showing more spine and some of the structuring extremes are being exposed. This is the first sign of a cleansing of the genetic pool in the loan market." The leverage multiples attempted in some of the transactions that have had to be restructured have certainly been extremely punchy and call into question the logic behind some of the trades. The days of the private equity sponsor actually repaying the debt it assumes are long gone – it will now be repaid by sale/IPO or refinancing. And so what is happening is that the market is bridging to itself – and those bridge loans (which are being written on "exploding" terms – that is, very steep step-ups) have been sold in vast quantities to hedge funds, which will take an aggressive attitude to any subsequent renegotiation.
| Just as markets get skittish, supply increases |
| US leveraged institutional pipeline |
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| Source: Reuters Loan Pricing Corporation/DealScan |
| A flight from risk? Perhaps not in june |
| Bid level changes in SMI 100, cov-lites, second liens, first liens |
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| Source: LSTA/LPC MTM Pricing |
| Moving apart |
| Percentage change in spreads on indices |
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| Source: Markit, UBS |
But with market dynamics stretched to breaking point, it was inevitable that something had to give. With leverage multiples hitting nine or 10 times ebitda, the opportunities to sell or refinance at a higher multiple must be few and far between, and there are presumably only so many times that a firm can be flipped from one private equity buyer to another. "There is a finite amount of leverage you can take before the company cannot even pay the interest," says Prest at Close Brothers. "People need to look at some of these structures and ask: ‘How are we going to get repaid?’ Is it reasonable to assume that you can sell or refinance at an even higher multiple?" The equity sponsor mindset has changed beyond all recognition. Initially they were looking at an investment of three to four years before an IPO, and the market then moved to a secondary or tertiary buyout within two years. Now a buyout is no longer necessary – the sponsors know that they can simply refinance at any time and threaten everyone with being taken out at par.