Glass half full

Times have changed. The market fuelled by cheap debt has come to an abrupt end and its ramifications are still not fully known. The megadeals will surely be back, but not in the short term and not in the numbers that they were this time last year. The change in times is epitomised nowhere more glaringly than by the rescue of Bear Stearns by JPMorgan – a spectacular casualty of the trillion-dollar meltdown.

Although the backlog of deals awaiting syndication is beginning to diminish in the US, things are proving a little more stubborn to unblock in Europe. Whether it is because of the maturity of the secondary market on this side of the Atlantic, the sheer size of the deals being done just prior to the onset of the credit crunch or the uncertainty surrounding the worth of existing loans on the banks’ books, the size of the backlog in Europe is thought to be at the same level as it was in July last year.

However, the debt markets are open for business – it is just that the market is different. Relationship banking is back in favour and traditional leverage, pricing and covenants are returning. Given the uncertainty surrounding the banking industry, private equity firms are being forced to consider new ways to finance their deals. It was not uncommon for leveraged loan structures to incorporate many layers of capital. However, institutional investors are continuing to stay away from the market, which has resulted in the second-lien loan effectively disappearing. The mezzanine market, on the other hand, is buoyant and liquid.

Alternatives such as pension funds, hedge funds, mutual funds and sovereign wealth funds are being approached to finance deals. Hedge funds are extremely flexible in where they are prepared to invest in the capital structure. Sovereign wealth funds, with estimated combined resources of up to $3tr (£1.49tr), are an obvious source of finance.

However, whether they are able to fill the void left by investment banks remains to be seen. Given that many are in their infancy, the resources and organisation required to handle big debt investments will be stretched to the limit. Also, considering the relatively low returns on debt, it is not clear whether sovereign wealth funds would be interested in the level of risk involved. Another alternative for buyout firms is to take advantage of the credit crunch and buy debt that is trading at below-par levels. Indeed, it is during such downturns that the best investment opportunities typically emerge, with valuations being cheaper than previously. Not that it will be simple: some of the debt may well carry terms that could make it difficult for private equity firms to buy bonds in their own portfolio companies.

Private equity firms are increasingly looking towards emerging markets that have not suffered the full effect of the credit meltdown. Local banks in emerging markets are aggressively pitching finance packages to private equity firms in an effort to win business from international rivals that are currently unable to lend.

There remains strong interest in particular sectors, such as natural resources and renewables, but the high street and the consumer sector are generally not seeing the same level of interest.

With the number of participants in the market having shrunk and the ability to syndicate remaining a challenging proposition, it is no surprise to see that there has also been a shift in the terms upon which loans are now made. We are seeing a more cautious approach permeating the markets, bringing with it a return to tighter risk management – a more traditional banking model.

As has often been reported, leverage is lower and pricing is higher. Covenant-lite deals – the use of incurrence-based as opposed to maintenance-based covenants – are virtually nonexistent. Mulligan clauses and reverse flex clauses are rarely seen. The use of the certain funds concept in private acquisitions has remained, but equity cure provisions are more limited, with fewer rights of repetition on cashflow-related cure rights. The result is that cashflow control has never been more important.

Reverse break fees are now being seen. With banks being prepared to walk away from deals, having been advised that it would be cheaper to do so than incur further losses on their funding commitments, vendors are beginning to require the reverse fee. There will be a renewed focus on documentation with a view to providing greater certainty and detail at the commitment paper stage.

Notwithstanding the significant writedowns made by the investment banks, the private equity market is still an optimistic place. Private equity will continue to thrive on the illiquidity that has caused problems for others. Private equity houses have vast sums of cash to invest. Fundraising remains extremely healthy. The market will most certainly bounce back, but its return will be on more traditional credit, leverage, covenant and pricing terms. There has without doubt been a large market adjustment, but it is one that many have argued was long overdue. Whether we have seen an end to the changes remains to be seen. nStuart Hill is a partner in corporate finance and Milton John Osborn an associate at O’Melveny & Myers