The meltdown in the US sub-prime mortgage market has prompted commentators to remark on the end of the abundant supply of cheap and easy debt and warn of tougher investment conditions for private equity funds.
Summer jitters surrounding the failure by Deutsche Bank and JPMorgan to sell down £9bn of senior debt underwritten in the acquisition by Kohlberg Kravis Roberts of Alliance Boots have reverberated into the UK private equity market.
Concern gave way to alarm in the autumn following large losses suffered by some of the world’s most influential lenders. US banks Citigroup and Merrill Lynch projected billion-dollar mortgage-related write-downs and HSBC revealed that it expects to write down $925m (£449.17bn) of investment banking debt in the third quarter of 2007.
Buyout activity was fervent in the first half of 2007 and while deal activity has slowed, a backlog of unsyndicated buyout loans needs to clear before lenders are prepared to provide funding commitment on the more borrower-friendly terms prevalent prior to the credit crunch.
So is the heyday of the buyout market over? Certainly, the credit squeeze means lenders are unwilling to entertain finance of more than £500m. However, leveraged funding remains obtainable, particularly in the mid-market, and the more creative private equity investor can take advantage of the volatile market.
Debt: the new deal
Until recently, the success of the leveraged model, predictability in the debt markets and the ease of syndication resulted in a ready supply of cheap debt on relatively favourable terms, culminating in covenant-lite terms.
The new reluctance of lenders to carry debt and the fear of defaults has made upfront risk assessment key. A lender’s ability to syndicate rests on an attractive debt package, credit quality and tight loan documentation. The commoditisation of the debt package has come under scrutiny, and stricter covenants and a re-examination of standard terms is predicted.
For the private equity investor this more tailored approach means that securing buyout funds in the coming months may become costly and time-consuming.
Whereas previously lenders were able to provide certain funds at short notice, the importance placed on primary syndication and getting comfortable with risk has meant more time is being spent on due diligence and on a detailed review of the legal documentation. Tight vendor-driven timetables will no longer be the norm and the pace of the deal is more likely to be governed by the lender.
So what is the cost of the increased risk in the market? Lenders are pricing high and looking for control, with stricter financial covenants and more onerous information obligations. For an industry used to lenders dancing to its tune, the new deal is proving to some unpalatable.
Alternative forms of finance: future trends
The credit crunch has already impacted on the way private equity funds do business, but the leveraged market is not confined by regulatory boundaries and is able to adapt. The industry is looking for non-traditional solutions to the funding problem: options include integrated, hedge fund and vendor finance.
Although not a typical source of primary finance, hedge funds have been increasingly active in the secondary market. Funds under management available for liquidation are such that full funding is not likely to be viable on all but the smallest of buyouts. However, debt from hedge funds can be useful to a private equity fund looking to club a deal upfront.
In its recent buyout of Goodman Global, Hellman & Friedman used a consortium that included hedge funds Farallon Capital and GSO Capital for finance.
Financing with a varied selection of lenders dissipates the risks associated with hedge fund financing, but creates a new set of problems. Bringing together a syndicate of diverse lenders may result in a clash of cultures and standardised terms, making negotiations lengthy and ongoing operations difficult.
Integrated finance providers have long been a feature in the private equity market. Specialist players have formulated the ability to provide equity while also underwriting the senior debt. Traditional private equity funds generally have the cash available to follow suit but have instead turned to lenders to produce the best leverage. Lack of experience combined with fears over syndication inhibits private equity funds from financing buyout debt at levels other than small cap.
However, a trend towards private equity houses seeking leverage in the form of integrated finance may be emerging. Although potentially complementary, a more passive role may not be acceptable to some. In addition, having lenders so close to day-to-day operations might be a concern for a private equity investor.
In a bid to keep prices high, vendors are increasingly being induced to part-finance sales by way of loans at sub-market interest rates. In the summer Daimler funded private equity house Cerberus $1.5bn (£730m) to secure its disposal of Chrysler in the wake of the first tremors of the credit crunch. Subordinated loan notes bearing minimal interest, few financial covenants and long maturity dates are an attractive alternative for borrowers struggling to find acceptable mezzanine finance and bridge the gap created by the reluctance of lenders to provide short-term bridging loans.
A lack of credible investments in the UK market has meant that cash-rich, target-poor funds have pools of uncommitted cash. Cheap debt allowed private equity funds to pay inflated prices for assets and often cut trade buyers out of the race. While the cost of debt spirals, a slowdown in deal turnaround is inevitable. Meanwhile, the benefit of this volatility is an adjustment in the pricing expectations of vendors.
The market is slowly re-grouping. Although the era of the mega-buyout may be over for the foreseeable future, the number of small to mid-cap transactions could be on the rise.
•Mark Davis is head of private equity and Eleanor West is an associate at Taylor Wessing