Magic circle moves into middle lane as banking bubble bursts

Can mid-sized firms fight back as the UK elite elbow their way into midmarket?

At The Lawyer’s Hot 100 party, held at the Royal Exchange last month, a group of leveraged finance lawyers were standing at the bar ruefully exchanging experiences. Banking lawyers are still working, it’s just a rather different landscape; and a consensus is definitely emerging around the shape of the acquisition finance market.

Midmarket: it’s so hot right now

“The midmarket is the new big market,” says Linklaters partner Gideon Moore in a typical comment.

“The midmarket’s definitely holding up well,” agrees CMS Cameron McKenna partner Will Meredith. “What’s surprising is the amount of activity still out there.” Certainly, the value of deals has dropped remarkably. The magic circle firms are routinely advising on deals under £1bn and as little as £100m.

Look east for the transactions

“People are going where there’s capacity,” observes Allen & Overy (A&O) partner Stephen Kensell. “There are smaller businesses being bought in the UK and emerging markets are of great interest. You can’t get many deals more than e750m [£557.97m] at the moment, and that’s pretty much the sweet spot for emerging market deals.” Banking lawyers cite Russia and Eastern Europe as particularly fruitful markets at the moment.

Everyone loves HSBC and Lloyds

At the height of the boom the clients to die for were the private equity houses, followed closely by the bulge-bracket US banks.

Nowadays classic clearing banks such as HSBC, and particularly Lloyds, are attracting attention. “They’ve got a fantastic corporate franchise and a good customer base,” notes a City lawyer who has worked with them. “And their lending criteria are pretty conservative – they weren’t doing stuff the US banks were going crazy for.”

Over the past 18 months HSBC and Lloyds have targeted the midmarket with success.

HSBC has made some astute hires from Royal Bank of Scotland (RBS) in its leveraged division, while Lloyds has entirely reinvigorated itself and is creating a buzz among lawyers. The latter operates a two-tier panel system in acquisition finance; firms have to be on the panel, but that panel is sufficiently varied to allow the bankers flexibility. Deals from managing director Ian Brown’s division tend to go to the magic circle. The midmarket team led by Neale Broadhead has used firms such as Ashurst, DLA Piper, CMS Cameron McKenna, Herbert Smith and SJ Berwin, among others, despite its longstanding institutional relationship, which is rather more active on corporate lending for the bank than acquisition finance.

The in-house legal team is not hugely involved except on crucial policy issues; Lloyds tends to follow an RBS model rather than a heavily lawyered Barclays Capital approach, where internal lawyers sign off on term sheets and commitment letters and review interim and final drafts.

Club deals are everywhere

Such is the nervousness among senior lenders that old-fashioned club deals are back.

“You’ll get three or four banks now and the quantum is lower,” notes Herbert Smith partner Chris Fanner. “They’re holding each other’s hands,” agrees Meredith.

No more recaps any more

The liquidity crisis has had an immediate effect on a major source of work for banking lawyers: recapitalisations. Documents are still full of restrictions in making capital expenditure, making acquisitions, disposals and paying dividends. The difference is that the company cannot change things by refinancing cheaper. “Around 40 per cent of the boom market was recaps,” estimates Clifford Chance partner Mark Campbell.

Interestingly, the threat to the monoline insurers may mean that infrastructure projects will resort to traditional debt financing, argues Meredith, which in the medium-term may mean more work for banking departments.

No fancy docs

In less exciting times, lawyers would routinely take guarantees and security from all companies in a group, but as the leveraged buyout (LBO) bubble grew and time pressures mounted, this started to drop – sometimes as low as 70 per cent by value. One partner says: “The position on many deals was that you wouldn’t get security until 90 days after you got the money. It was just too much of a hassle to do it on completion. It’s now a discussion point and some people want it on the day.”

In 2008 there will be no PIK notes, no interest toggles, no cov-lite, no second lien. “There’s more rigour around financial covenants and less of the exotic features,” says A&O’s Kensell. “They’re off the table.” Linklaters’ cov-lite glory, then, was short-lived. “We were top of the market on that for about three weeks last year,” Moore jokes.

Sponsors are still calling the shots

Although one US investment bank is rumoured to have tried to flex its muscles and refuse to accept sponsors imposing their choice of lawyers, in practice the pendulum has not swung back.

“Lots of underwriting banks hoped for a total reversal in the negotiations,” says an LBO banker, “but that hasn’t happened.” A finance partner agrees that the balance of power has not shifted fundamentally. “We’re doing papers on a deal and you know the bank isn’t going to do it – it’s just to keep their contacts warm at the private equity house.”

Old-fashioned lawyering

“It was a distribution-led market,” says Kensell of the LBO bubble. “It’s now more back to first principles, sometimes about knowing what was going on three or four years ago.” Does this mean lawyers are getting paid quicker? Most say yes, but opinion is not uniform.

However, Campbell at Clifford Chance remarks: “Clients need advice more than they did before. It’s a market that went from credit protection to one where it was all about distribution. Now it’s moved back, and that means lawyers’ input is more valued.”

Truly, a happy ending. But the smaller firms will not give up their midmarket position to the magic circle without a fight. “Yes, the brand goes so far and the quality of partners is there,” says a banking partner at a medium-sized firm. “But there’s a lot of quality knocking around the midmarket too.”

Expect some frayed tempers before the year is out.