10 March 2008
The day of the jumbo leveraged deal is over for now, with fund investors that previously invested in the leveraged loan markets still unable to get funding from the short-term debt markets.
Arrangers of the pre-credit crunch jumbo deals are working hard to try to offload commitments without sacrificing too much of a discount. In addition to the dearth of jumbo deals, there is little opportunity for recapitalisations and it will be difficult for sponsors to do 'bolt-on' acquisitions using existing financing documents without there being pressure to amend the now 'off-market' debt terms.
However, notwithstanding the significant writedowns made by some investment banks, the private equity market is still not out for the count. There are three key areas of activity, the first being mid-market deals (involving financing of between £100m and £1bn), which historically tend to have more bank-friendly terms and, because of their size, are easier to syndicate.
As magic circle firms increasingly advise on mid-market deals, the more aggressive sponsor-friendly documentary terms are creeping in, albeit the commercial terms are far more reflective of the credit risks than they were pre-credit crunch.
Mid-market deals in less mature European markets such as Eastern Europe, Turkey and Asia tend to be more reliant on financing from local banks. Local financiers, which may be less syndication-focused, are able to offer better terms and are thus supporting growth opportunities in such emerging economies.
The second key area of activity is infrastructure deals which, given the stability of cash flows and debt multiples, use leveraged finance techniques.
Third, sovereign wealth funds and Middle Eastern private equity houses are increasingly investing in Europe, although recently these have been attracting political debate.
Deals in the current climate
It is deal economics that really matter now, and there are five charateristics that can be seen in the deals completing in the current market:
• Good credit. That is, recession-proof businesses such as pharmaceuticals, media, mining, energy and infrastructure.
• Lower leverage multiples and therefore conservative covenant headroom.
• Pricing that is more reflective of the credit and at a price required to effectively compete in the secondary market where existing deals are trading below par.
• More conservative in size and smaller percentage underwrites. Even where arrangers may be willing to underwrite 100 per cent of the debt, sponsors are demanding quasi 'club' deals of two to four banks for debt packages as low as £200m in order to limit the syndication risk.
• Equity percentages of up to 40-50 per cent, compared to historic pre-credit crunch lows of around 18 per cent. This reflects the lag between vendors' expectations and the availability of debt financing. The equity component is plugging the gap between the debt and equity markets.
The role of external legal advisers
In these days of tight credit and significant writedowns it may seem logical that arrangers will set their sights on decreasing external legal spend. However, in practice the reverse is true.
In the years leading up to the first half of 2007, arrangers were concerned primarily with the distribution risk of selling their underwritten commitments. The M&A market in Europe is historically a vendors' market, which has seen compression of timelines to be the first across the line to support a purchaser's bid.
The question pre-credit crunch was not whether something was right from a credit protection perspective, but rather whether it had been done before and sold on that basis. Arrangers are now investing more time and cost in finding a good credit that will sell well, and there is a more balanced focus on both credit and distribution risk. It is this shift in focus which is requiring far more 'lawyering' of transactions in a number of ways:
• There is more due diligence compared with pre-credit crunch when deals (and not just recaps) were being done on the basis of very little due diligence.
• Arrangers' credit committees are far more focused on security and it is becoming important to stress-test structures using insolvency analysis.
• As a consequence of sponsors and arrangers accepting funding at acquisition levels less than that required to squeeze out minority shareholders, arrangers are focusing on all the ramifications of the remaining minority stake.
• Syndication is starting pre-closure, with syndicate banks appointing their own external legal counsel to review the documents at an early stage and often pre-signing, resulting in far more negotiation on the underlying documentation.
Although documentary terms have become relatively more 'bank-friendly', they have not improved as much as one would expect as a result of the credit crunch. There are a number of reasons for this. First, it could send a signal to the market that something was wrong with the pre-credit crunch terms. Second, sponsors are still able to use relationship pressure in negotiations. And finally, lenders are focusing more on the economics rather than improving documentary protections for the sake of it.
There is a fine balance in ensuring that strong credit protection remains, even if documentation is still not entirely bank-friendly, and arrangers are turning to external legal counsel for advice to achieve this balance.
More to come
The changes in leveraged financing documentation made in the pre-credit crunch days may mean that deals will not allow lenders to renegotiate or restructure until a significant time after problems appear, given poor covenant protections in the pre-credit crunch deals. At this point there may be a far greater need to negotiate to reach a solvent outcome than would previously have been the case had lenders been able to step in at an earlier point in time.
In the days of easy credit, the lenders simply sold the debt and moved on. Lawyers' input is far more valued now - not only in helping to structure new deals but also in dealing with stressed or distressed credits.
Annette Kurdian is a partner at Linklaters