ING • LBO financing: a changing landscape
Institutional investors made 2006 a watershed year for Europe’s leveraged finance market. They not only took centre stage by becoming the market’s main source of liquidity, but have remained there ever since. ING’s Paul McKenna describes their impact on current market trends and how their new prominence has changed the roles of the established players.
Following two record-breaking years, the momentum in Europe’s leveraged finance market shows no sign of abating. Although 2007 first quarter’s volumes fell just short of the previous year’s total, deal flow remains strong in absolute terms, and market conditions remain highly supportive of LBO activity. Abundant liquidity is still the key driver of market conditions, which has caused the benchmarks for deal size, pricing and structure to be repeatedly redefined. In 2006, demand for product saw new European issuance records set for mezzanine, second lien and high-yield. The US market saw RJR Nabisco’s long-standing record as the largest ever LBO surpassed by healthcare business HCA, while keynote European transactions included the buyouts of Dutch cable business Casema, with its record ING-led €1 billion mezzanine tranche, and NXP, the former Philips Semiconductors business, which brought Europe’s largest ever high-yield issue at €4.5 billion. With default rates still well below historical averages, economic conditions remaining benign, and private equity fund sizes ever increasing in size, I expect that 2007 will bring more of the same. Notably, closer inspection reveals significant differences between 2006 and 2005 which, taken together, provide important clues about the market’s future performance. While both of the previous years broke records in terms of volume, the sharpest growth in volumes occurred between 2004 and 2005, when the market nearly doubled in size. In contrast, the €116 billion generated via 248 deals in 2006 was only about 2% ahead of the previous year’s total – a significant reduction in growth. This may be due to there being fewer LBO "elephant-sized" financings in 2006, which have a significant effect on overall volumes. Instead, mid-market LBOs were the real engine room of the market in 2006, causing average deal size to drop from around €520 million to €400 million. Meanwhile, the percentage of €1 billion-plus deals dropped to around 6% from 15% in the previous year, meaning 2006 was a return to recent historical norms. Jumbos such as TDC, VNU and Ineos may have an unwavering ability to create headlines, but recent public-to-privates, such as the bids for Sainsburys or Quantas, show these deals to be capricious at best.
At the same time, there has been a significant change in the role played by institutional investors, who continue to enter the market in pursuit of superior relative value offered by the leveraged senior and subordinated asset class. In 2005, funds were perceived as providers of that last deal-winning turn of leverage, a top-up to the traditional liquidity sources, the banks. In 2006, however, investors achieved critical mass in Europe, transforming them into major participants in any syndication process. This change has been driven by a relentless influx of new institutional investors, primarily from the US, and a significant increase in the "bite size" of the established players, either as a result of issuing repeat funds or diversifying through use of vehicles such as open-ended market value credit funds, low-levered CLOs and pro-rata vehicles. The change means between 75% and 100% of a financing can now be provided by the institutional market, raising serious questions about the future role of banks as liquidity providers.
The arrival of these funds means that despite the growth of the market, burgeoning liquidity levels have outstripped the amount of available product. The market re-pricing that characterized 2004 and 2005 has developed into unprecedented structural aggression, including a significant rise in leverage levels, increased numbers of equity takeouts via add-ons, and an erosion of covenants. Leverage has been rising steadily, from an average of 4.6x net debt-to-Ebitda in 2004 to 5.5x in 2006. Over the same two-year period, the number of LBOs with a leverage multiple of six or greater grew to 37%, up from only 13%. This trend is particularly marked above the €2 billion deal size mark, where the average leverage obtained on established credits is seven times, a level that even mediocre credits can obtain.
Of the various pressure points, senior pricing could be the one to stabilize first. Certainly the European market "standard" of 225/275/325bp on the senior is a thing of the past, having reduced first to 200/250/300 and then to 187.5/237.5/287.5. While flex remains the main mechanism of price discovery, CLOs may find their room to manoeuvre becomes further restricted by their cost of funds, despite the fact that this has also been reducing steadily. Further resistance to downward pricing pressure may also stem from the reduced yield on other areas of CLO portfolios, in particular the US sub-prime market, of which the knock-on effects may have yet to be felt. And if ratings agencies were to begin taking a more critical view of the increasing financial risk in the leveraged assets being booked in CLO portfolios, there would most certainly be an impact on pricing.
The effect of the supply/demand imbalance has been most apparent at the subordinated end of structures, with the market for mezzanine debt providing one of the most striking examples. While the appetite for mezzanine has grown rapidly, a migration of debt towards the senior end of capital structures has led to a sharp fall in the amount of mezzanine product available. While the main mechanism for this remains recapitalization via an all-senior or senior/second lien structure, the latest development is for sponsors to cancel the mezzanine following or prior to a successful syndication, transferring it instead to the B and C senior debt tranches. So far, 2007 has seen well over €1 billion of mezzanine cancelled on deals including PagesJeunes, Kion, Phadia, HC Starck and Dockwise.
The dwindling supply of this asset class is particularly bad news for the specialist mezzanine funds, once a stalwart of the European scene, as the available product is increasingly packaged up to enhance the blended yield for those investors that can play right across the debt structure. As a sting in the tail, mezzanine pricing also fell from an average of 964bp in 2005 to 935bp at the start of this year. While most of this debt has been transferred to senior tranches, Pay-in-Kind (PIK) instruments have also increased in popularity due to their recently improved call structure and lack of cash debt service requirement until maturity. Popular with funds and equity alike, these have made a dramatic comeback in both note and loan format, with the likes of Wind, Tim Hellas, Panrico, Weetabix and Brake Bros all issuing PIKs to pay sponsor dividends, refinance or make acquisitions. Although the most risky and volatile part of the capital structure, their use as a form of cheap equity by sponsors means they are likely to remain a feature of the market in 2007.
Although growing influence of institutional investors can be seen as part of the tendency of US market practices to eventually cross to Europe, some of the most recent developments have met with some controversy. In particular, the adoption of "covenant-lite" documentation has stirred up a hornets’ nest of dissent in some quarters. From a sponsor’s perspective, this may appear to be a logical progression, given that many are originally US-based entities that are increasingly dealing with US-based institutions. The key difference lies in the legal jurisdictions in which they now operate, many of which lack the mechanisms for creditor protection that are such established features of the US system. Moreover, although the European secondary market has developed rapidly since 2004, it still lags the US in terms of transferability. This is not necessarily due to sponsors’ attempts to place restrictions on the make-up of their lending group, but could simply be caused by the fact that the European market does not yet offer sustained liquidity at the full range of price points. It follows that investors in a stressed or deteriorating credit are likely to be less comfortable with being asked to give up their incurrence covenants in the first place. However, now that the trend has gained a foothold via recent deals such as TNT, VNU, and Trader Media, it is unlikely to be reversed. Going forward, it may be that the covenant-lite option will only be available to a select group of sponsors that can command sufficient trust among investors in their ability to turn around a struggling credit, be limited to deals in the more stable sectors or in financings for industry champions, and -- given the more conservative bank lending market -- only be possible on deals where the sponsor is willing to accept limited undrawn facility flexibility. Alternatively, it may well become market standard across the board on the grounds that liquidity is simply so great that sponsors are able to dictate their terms even in this respect.
Taken together, these trends show how the growing influence of the institutions has created significant challenges for commercial banks. Historically the main providers of liquidity to the LBO market, lending banks are being squeezed out of the market. For those commercial banks which in addition to lending also arrange and syndicate, challenges lie in how such banks reach their underwriting decisions, as the traditional arguments surrounding credit risk must now be broadened to take account of market and syndication risk, shifting internal priorities from that of an asset holder to that of trader and adviser. The parallel with the investment banking model does not stop at being distribution-led however, as sponsors increasingly demand the ability to offer the full range of debt products, which in turn is driving a convergence of the public and private debt markets. Ultimately, the winners in this new, fund-dominated market will be those arranging banks that adapt the most effectively to the new realities of the intensely competitive marketplace.