29 June 2009
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With leveraged finance hit hard by the credit crunch, Stuart Brinkworth considers what’s in store for the beleagured sector
There is no doubt that the last two years have been the toughest in living memory for the leveraged finance market. Problems first began in the summer of 2007 with the onset of the credit crunch following the US subprime mortgage crisis. This led to a liquidity crisis, with banks finding themselves unable to source funding for new deals, and liquidity became worse not better throughout 2008.
Next came probably the worse banking crisis ever seen in modern history, with the collapse of Lehman Brothers in September 2008, which destroyed confidence in the sector and led to full or part nationalisation of UK banks, such as Northern Rock, Royal Bank of Scotland (RBS), Lloyds TSB and Bank of Scotland.
As if this was not enough, the beginning of 2009 has seen the onset of the worst economic crisis since the Great Depression of the 1930s. During this period we have seen the UK’s largest-ever corporate loss (RBS’s £24bn) and the biggest manufacturing collapse in US history (General Motors).
For leveraged finance this ‘perfect storm’ has had a profound effect. In the first quarter of 2007, widely recognised as the peak of the market, $106bn (£64.45bn) of debt was provided for new buyouts. That figure dropped to $1.4bn in the first quarter of 2009, representing a 99 per cent drop.
The economic crisis has also seen default rates rise dramatically. By the end of 2010 it is expected that up to 24 per cent of leveraged deals by number (20 per cent of deals by value) will be in default. Mezzanine lenders have been the worst hit. Unlike the restructuring cycle of 2002, when the value ‘broke’ in the mezzanine (giving mezzanine some value in restructurings), because of the high lending multiples of ‘earnings before interest, taxes, depreciation and amortisation’ (Ebitda) typified by the credit bubble of 2006-07, combined with the steep drop in valuation multiples as a result of the economic crisis, the value in most deals is breaking in the senior debt, leaving mezzanine lenders on many deals literally wiped out.
With many mezzanine funds themselves leveraged, this is expected to lead to some significant losses in some areas of the mezzanine industry, particularly with those participants that followed the market in 2006-07 rather than those that took a more cautious approach to credit.
Private equity itself has also suffered. Raising cash for new funds has become increasingly difficult, albeit not impossible. With fewer realisations due to dropping valuations and increasing defaults, investors in private equity funds have suffered from their own liquidity crisis and the fear of investor default hangs over the industry. Many believe that some private houses will disappear altogether and that the industry may go through a period of consolidation, with only the most established and experienced players surviving.
So has this perfect storm set in motion a paradigm shift in the way that buyouts will be funded going forward?
In the big-ticket market there is some sense of a paradigm shift occurring. Debt funding for large cross-border transactions is going to be in short supply for the forseeable future. The debt for these transactions has historically been sold to institutional investors and collateralised debt obligation (CDO) funds. With the CDO markets in particular showing little sign of attracting new money, it is unclear where participant demand for this kind of debt will come from, raising issues as to the viability of underwriting. Instead deals of this size will undoubtedly be fewer and vendor finance will have a big part to play. The Barclays iShares deal is a good example of this.
The mid-market, in contrast, is showing no evidence that a paradigm shift will occur. Lending activity has continued, albeit on a much reduced basis. For deals up to £300m in enterprise value, almost £12bn was made available in 2007, with that falling to £7bn in 2008 and predicted to fall to around £2bn in 2009. Mid-market bankers expect lending to continue along a steady path, with lending levels in the mid-market predicted to reach around £4.5bn in 2013 (equivalent to 2004’s levels).
So where does this leave leveraged finance? There is no doubt that certain aspects of the leveraged finance market have changed as a result of this perfect storm, in particular:
- the cost of funding for all banks has increased permanently;
- as a result banks will lend less and charge more for leveraged loans;
- banks will not create a market for leveraged loans or go after market share as they did before - a need for borrowing will need to be justified and lending will be more selective;
- banks and mezzanine lenders will insist on structures with significantly less leverage than before - meaning equity cheques will be bigger and average deal sizes will reduce as a result;
- private equity will have to focus more on deal origination and creating growth and value - ever-increasing lending multiples will no longer be available to fuel a secondary market or recapitalisations; and
- non-bank lenders, in particular debt funds, will have a greater role to play in the capital structures of deals going forward.
However, these changes can hardly be described as a paradigm shift, more a response to the perfect storm outlined previously, which will see a period of responsibility and caution in lending practices. Nothing revolutionary about that.
So while leveraged finance may appear to be in jeopardy, it is not scuppered in the mid-market at least. But the key to its recovery is whether the storm currently raging is truly subsiding or whether we are simply at the epicentre. The economy, like the weather, is unpredictable, and there will be many choppy waters to be navigated before safer seas are reached.
Stuart Brinkworth is a finance partner at SJ Berwin