Best of both worlds
15 May 2006
Not so long ago the US and European leveraged finance markets were distant cousins, bearing little resemblance to each other. If you turn back the clock in Europe just five years, the leveraged lending landscape would look radically different. It was dominated by European banks, with little differentiation in pricing and the use of relatively similar debt financing structures across the board.
But the arrival of US sponsors and investors, and the significant growth and adaptation of European ones, changed all that. The European market is now just as robust as its older counterpart, every bit as sophisticated and equally, if not more, dynamic. In fact, a mark of how much the European market has evolved is the fact that practices that have developed in Europe are now crossing the pond to the US. However, differences remain, and in a market where both sponsors and investors are likely to have a foot planted in both the US and Europe, understanding them, and the similarities, can be critical.
Convergence between the UK and US
The arrival of US money into Europe has led to a convergence of the investor base in the two markets, with around 40 per cent of investors on both sides of the Atlantic now constituting not banks, but collateralised debt obligation (CDO) and collateralised loan obligation (CLO) funds, hedge funds and other alternative investors.
US investors are now frequently buying European debt and vice-versa. Global sponsors now operate in both markets, with larger target companies frequently having global operations.
In turn, this evolution in the investor and sponsor base kickstarted product development in Europe. Formerly, the European market featured predominantly senior and mezzanine debt financing. However, a number of US-originated products, such as high-yield bonds, second lien debt and pay-in-kind (PIK) instruments have crossed the Atlantic into the European market, meaning that Europe has as diverse a range of products as the US, and given the strength of the European mezzanine market, arguably a greater number. Of course, the implementation of some of the products in Europe is somewhat different from that in the US, but the broad-brush picture is remarkably similar.
Sponsors, which due to favourable market conditions (benign default rates, high liquidity) have a relative negotiation advantage vis-à-vis lenders in both markets, are capitalising on this convergence and are using their dominant position to gain the terms they want. Sponsors expect their banks - which are, after all, global financial institutions - to provide the best of both markets and they are not afraid to use their leverage.
The sophisticated refinement of the bid process, and the rate at which 'consortia' deals are becoming more frequent due to the increasing value of target companies, means that sponsors have had ample opportunity to learn both from each other and from common advisers and are using this experience to improve their position. The result is that, in Europe, although not yet in the US, the first set of documentation will be sent by the sponsor's lawyers. Additionally, other differences in underwriting and syndication processes in Europe have led to a better management of competitive tension among underwriting banks - a practice that has found its way back to the US.
This convergence and the heightened competition it engenders has had a predictable outcome on pricing. Standard transaction pricing was previously a feature of the European market, but competitive, flexible US pricing practices have migrated to Europe. Five years ago, market flex, whereby arrangers are able to increase margins to ensure successful syndication, was unused in Europe. Today it and its opposite, reverse flex, which enables borrowers to trim margins when a deal is strongly oversubscribed, are common features in both markets. In fact, in Europe sponsors will often include reverse flex incentive terms in their contracts with lenders, a situation that has yet to occur across the Atlantic.
Are the differences mere nuances or major issues? The answer is, in fact, both. As outlined above, there are variances in techniques and products that need to be taken into account. However, there are also more fundamental distinctions, stemming from the fact that the US is a true single market (albeit with some legislative variation at a state level), while Europe is a collective of countries with different legislative and financial regimes as well as cultures and political agendas.
The upshot of this is that structuring a transaction in Europe is frequently far more complex than in the US, particularly given that many European deals are cross-border. European laws in most jurisdictions make it more difficult than in the US to take security over certain types of assets, particularly future or changing assets. Civil law, the basis of most European legal regimes, requires tangibility: if you cannot touch it, see it or feel it, you cannot take security over it. In addition, there are financial assistance and strict corporate benefit issues in Europe that add to the complexity of structuring transactions.
The effect of both of these factors, as well as the need to be tax efficient, is that pushing debt in a leveraged buyout (LBO) down from the holding company to operating company level is a necessity in Europe, whereas there is no need to do so in the US. This not only adds complexity to deal structures, but also lengthens significantly the commitment period (or post-funding the bridge period) for lenders (thereby increasing risk), since the push-down process can take months.
Heightened execution risk goes hand-in-hand with this additional complexity. Deals are simply less likely to go through in Europe than in the US: nationalist political agendas, a growing activist shareholder and bondholder base, stronger rights for minority shareholders and the lack of squeeze-out rules in some jurisdictions are all notable stumbling blocks. When combined with the traditional European market principle of certainty of funds, where lenders have to commit to financing a deal at the bid stage with no possible get-out at a later date, lenders may invest significant time and money for little or no reward if the deal does not go through or is won by a competing bidder, or they potentially take on significant risk if it does.
Erosion of some of these fundamental differences is unlikely in the medium term since it requires major changes to numerous European legislative regimes. Market participants, however, appear willing to absorb more and more risk in order to continue to pursue their business objectives.
What is certain is that both markets will continue to converge in terms of industry practices, as players in both continue to exchange ideas and products. All eyes are now on the nascent Asian leveraged finance market, which is expected to grow rapidly in the near future, meaning more challenges and more evolution ahead.
Barbara Choi is a partner at White & Case