The 2007 guide to Leveraged finance
Current market conditions in European leveraged loans are as attractive for the borrower (and therefore the private equity sponsor) as they have ever been.
Market capacity has increased dramatically. Based on transactions in which Apax has been involved, we have observed senior loan market capacity increase from about €2.5 billion in 2004 to €8 billion in 2005; today the expectation is that a borrower could obtain €20 billion-30 billion in senior debt financing for an LBO. Combined with increased amounts of equity capital being raised and the ability to syndicate equity in the largest transactions, this leads to larger and larger opportunities for us.
Margins have decreased. ’Traditional’ pricing has been replaced with deal-specific margins below the historic market benchmark. Margins are further reduced with almost universal application of reverse flex, itself a concept that has only been in common use for less than three years. Whilst margins may be forced to rise in more challenging markets, pricing differentiation will continue.
Flexibility has increased. Covenants are being loosened or removed. Scheduled amortization is disappearing in senior loan structures. Subordinated debt increases in complexity, layering and flexibility. And what we can do with each company going forward – acquisitions, disposals, reorganizations, restructurings etc – is facilitated by a debt structure that contemplates these plans upfront. This helps us substantially with our objective of value creation.
The private equity community is well aware of the driver of these trends:
• liquidity generated by the arrival in Europe of the institutional investor
• the consequence in increasing leverage levels per transaction.
The popular press would have us believe that, in our festival of greed, we sponsors blindly take as much debt as is offered from ignorant lenders who care little for the risks they are taking. From our perspective, this is simply not the case.
Understanding the environment
We want to take advantage of the current environment but first we have to understand it. We focus very carefully on the financing of our transactions in the same way as we focus on each of the industry sectors in which we invest – full time, with a dedicated team. We also want to understand where the debt of our companies is going. We meet investors, build relationships with them, learn about their business models and select during the syndication process those with which we are comfortable. Key amongst these are our own limited partner investors (our "LPs"), who already understand our business and our investment strategy and have chosen to support us with their own capital. Other private equity firms have started their own debt businesses which give them their own window on the market. However it is done, having a proper understanding of the financing market and its participants is simply part of the large-scale buyout business today.
In taking advantage of current market demand, our motivation as an equity investor is very simple. We have a duty to our LPs to generate the highest return with the lowest risk. It is a basic business principle that leverage increases equity return. But we also know it increases risk. Increasing financial flexibility reduces that risk. What the institutional investor base has brought us is a pricing capability for that flexibility. We structure our deals more creatively and cost-effectively than ever before.
For example, when we (together with Texas Pacific Group) acquired the Greek mobile telecoms operator TIM Hellas, we understood the business’s requirement for operational headroom. We therefore structured with our banks the first all-bond financing for a new LBO transaction in Europe. This had the benefit of a flexible covenant package and no amortization, a product which was simply not available in the loan market at the time.
Covenant-lite
If we were doing that transaction today, it is likely we’d use a "covenant-lite" loan instead. If you had asked bankers during a financing pitch six months ago what exactly they meant by "covenant-lite" they’d probably have replied "I’ll get back to you". Now the first transactions are appearing in Europe and establishing the ground rules.
In the past month we have signed the first two true covenant-lite transactions in Europe: one (together with Cinven) a refinancing of yellow pages publisher World Directories and the other the acquisition financing of Trader Media Group. These deals are structured as a hybrid between bank loan and high-yield bond to offer the borrower a far more flexible financing structure than is available through a traditional leveraged loan. Market rumour suggests that the financing for Boots will be on a covenant-lite basis, although more closely aligned to an LBO loan with fewer covenants.
While banks and institutions may disagree on whether this is a positive market development for the lending community, it is nevertheless an evolution that has happened and is being priced by the market. We have even heard the traditional LBO loan being referred to as "covenant-heavy". Is this a sign of a new era or top of the market?
Riding out a downturn
So what will happen in a downturn? The first thing to consider is what type of downturn. Again, the popular press draws a causal link between market liquidity and defaults. Whilst there is undoubtedly some linkage, it is not at all clear that a downturn in financial markets, for example a decrease in the activity of new CDO vehicles, will have any impact on our current portfolio. It may limit refinancing options and reduce ultimate exit multiple but does not change equity capital at risk.
More serious would be the impact of the traditional cause of defaults – macro-economic downturn and recession. This is where clever debt structuring can help companies through more challenging times without triggering a default. But, if the worst does happen, the reality is that there are too few recent data points to predict the outcome of the negotiation process between lenders and borrower with any accuracy.
The value will go to the person who controls this process. This is when having a strong syndicate will help us as a sponsor. The debate will continue about the effectiveness of transfer provisions to prevent trading in a company’s debt. In our view, they are of some benefit but do have some associated cost. So this is a trade-off we make, deal by deal, that may be impractical on large transactions. It is better to have a syndicate from the start that is focused on long-term investment and with which we know we can work. Any private equity investor who remains in business for the long term will encounter this scenario. It is something to be prepared for, not something to be feared.
In the meantime, our focus is on executing the best transactions we can for our portfolio companies and keeping the balance between risk and return. If this means taking advantage of aggressive financing terms offered to us then that is exactly what we will do.
Neil Thomson is a partner with Apax Partners Worldwide LLP