15 May 2006
Private equity is showing no signs of slowing down after enjoying a record year in 2005 as the avalanche of European and US institutional money competed for what seemed to be a decreasing number of assets.
The emergence of Middle Eastern money into the European private equity market, the appetite of the hedge funds to compete in the same space as the traditional financial sponsors and the return of the trade buyer as European M&A bounced back only intensified this competition and generated even more auction processes. This year shows no signs of abatement, with 50 sponsor-backed loans closing in the first quarter alone.
A consequence of competitive auctions is higher prices for assets and, given the need to fund these acquisitions with debt and the insatiable levels of liquidity within the banking and institutional investor sectors, the market has seen debt multiples that have quite often made the eyes water. The larger deals in the market regularly have leverage ratios at eight and the average in 2005 was 8.3 compared with an average of 6.8 in 2003. Size matters in the world of leveraged buyouts (LBOs) because, for larger transactions in excess of E500m (£342.9m), the multiple last year was 8.8.
One might have expected banks funding this boom to have tightened their lending terms as they pile in with their cash, but the experience of the last 12 months has shown the converse to be true. This may be hunky dory while the institutional investor base continues to provide 40 per cent of primary market liquidity, but the sceptics are beginning to voice concerns.
Under pressure to win mandates, certain underwriting banks have increasingly relaxed terms to the extent that, in the last quarter, they have been offering facilities with no capital expenditure restrictions and proceeding with deals with no fixed charge cover. When one also considers that sponsors on a recent deal persuaded an arranger to remove a dividend restriction where the leverage was still as high as 5.5, you have to accept that the LBO market is about as benign as it could get.
Similarly, it seems that earnings before interest, taxes, depreciation and amortisation (EBITDA) cure rights, whereby sponsors inject equity and treat it as EBITDA to shore up a stretched financial covenant, seems to be a feature of the market. Anxiety that the sponsors are able to avoid a financial covenant default while the business is imploding in the background does not seem to be universal.
Structural subordination, which is designed to distance the equity and other forms of subordinate lender from the operating assets and the most senior of the debt in the capital structure, is also increasingly being undermined as lenders are asked to accommodate equity interests such as preferred equity certificates and sub-debt even at the senior borrower level, so that the sponsors can maximise the tax deductibility on such instruments. If these deals unravel, lenders may discover that contractual subordination is not all it is cracked up to be.
There is also a concern that the decline in pricing is not reflecting the underlying credit risks and this is being reflected in investor portfolios, which have had a declining rating from the rating agencies. Standard & Poor's European Leveraged Loan Index indicates that only 22 per cent of the index was rated double-B in December 2005 compared with 83 per cent in January 2003.
Pricing is suffering and interest on A loans at 2.125 per cent and 2.5 per cent on B notes is not uncommon, while mezzanine has featured as low as 8.75 per cent. You have to have a memory like an elephant to remember a mezzanine facility accompanied by warrants.
If you also bear in mind that target security is often limited by a myriad of security principles that limit the scope of the security, the grant of which in any event is often postponed for up to 90 days after closing, one begins to understand why leveraged loan credit officers might increasingly be inclined to reach for the sleeping tablets.
It is also an increasing feature of the market for the voting and consent mechanics to give sponsors a disproportionate degree of control and influence, and in certain instances even enable them to make adjustments to the capital structure.
The concept of 'facility change' specifically permits a releveraging of a facility, perhaps following a period of amortisation if all lenders in that facility agree and a majority of all lenders consent. This might mean that lenders in a C facility who do not have a blocking vote could see the A note commitments increase if all of the A lenders also agree. If you also bear in mind that a 'yank-the-bank' clause might permit the removal of a dissentient lender so as to push through a vote, the historical controls and comforts that lenders had in connection with issues such as releveraging are clearly being eroded.
Lenders are also being forced to stay awake and respond to circulars and notices from facility agents by virtue of 'snooze-and-lose' clauses. Failure to register a vote may mean that a sleeping lender is stripped out of a calculation for a constituency or an all-lender vote, which might not be ideal.
As the volume of money and the emergence of new sources of capital take the European LBO market to new heights, it is ironic that terms are softening. If liquidity in the primary and secondary markets wanes, it is possible that the army of restructuring lawyers looking to restructure an increasing number of impaired credits will not only arrive on the scene when it is too late, but will not have it all their own way.
Chris Howard is a partner at Freshfields Bruckhaus Deringer