A growing subculture
Despite predictions of a consortium-led deal boom, Europe's private equity industry is having a tough time. Delays to larger public-to-private deals have forced sponsors to recapitalise deals faster than ever before in order to make returns. As banks rush to provide structures to support them, the leveraged finance market is changing irrevocably. Adrian Simpson reports.
Having recovered from the downturn that forced them to clean up balance sheets and sell non-core assets, companies have returned in force to the acquisition trail, ending the recent spell in which the private equity industry was the dominant force on the M&A buy-side. At the same time, recovering equity values have led shareholders to regard the prospect of a take-private with deep suspicion, reasoning that if there is sufficient upside in their investment to attract take-private bids, they might as well remain in control. After all, these same shareholders have remained committed to businesses through the tough times.
These obstacles help to explain not only why sponsors are finding it difficult to source fresh deal flow, but also why deal numbers have been below expectations – even if the size of this year's deals has compensated on the volume side. So far two of the year's flagship take-private deals – for Danish telecom TDC and Dutch marketing services provider VNU – have been plagued by drawn-out timetables because of shareholder resistance.
As always, there is one sure way to break the deadlock – pay up. But herein lies the dilemma. Sponsors need to keep their equity input to a minimum if they are to provide their investors with a decent return. Private equity relies on a leveraged model of profit creation, after all. But without a decent equity contribution, sponsors cannot hope to achieve the multiples required to compete with the returning trade buyers. So how much equity is the right amount?
Increasingly, it is arranging banks that are providing the solution. The explosion in the syndication of subordinated debt, principally to institutions, has enabled the higher leverage multiples required to ease the equity burden, even if temporarily. The subordinated debt revolution that has ensued is not only changing banks' role in financing leveraged deals; it also threatens to change the nature of the market permanently.
"It's inevitable – this is how the US market has been for years," said Euan Hamilton, global head of leveraged finance at RBS. "The market is moving from a bank-driven model towards an institutional-driven model. The emergence of bespoke buyers has allowed the market to grow, both in terms of size and the scale of deals being done. The market couldn't have done a deal like TDC if it had been comprised only of banks."
Now that sponsors are targeting the large-cap market, it is unlikely that their return models will allow them to return to the mid-market space. During the last few years, sponsors have built portfolios of complementary, large-cap businesses. They are now entering an era where the buy-and-build tactics learned at the smaller end of the market can be applied on a larger scale. It therefore makes sense for them to value targets on the basis of future synergies as it does for a trade buyer – traditionally the reason why the latter would bid up the price tag beyond sponsors' reach. Already this year, Liberty Global was forced to bow out of the bidding for Casema, leaving Cinven and Warburg Pincus to drive the wave of consolidation in the Dutch cable industry.
The liquidity enabling these larger transactions has come not only from the traditional specialist funds, but also from hedge funds, banks and allocations from structured vehicles. Their combined thirst for the higher-yielding assets has driven an explosion of second lien and mezzanine issuance, radically moving the benchmarks for these assets.
"Until Casema, the record for mezzanine was [Gala's] £460m, and you couldn't have had a better credit story than Gala. Now the benchmark has moved to €1bn," said Ian Gilday, managing director in Goldman Sachs' leveraged finance division.
One consequence of the growing structural complexity has been to make banks' distribution capabilities more important than ever. "The strength of the distribution-led approach lies in having the best relationship with all investor types. It allows you to predict accurately at any one time what investors want and therefore what you can place," said Gilday.
Distribution is key
But it is not just the investment banks that are waking up to this approach. Although the large commercial banks' models demand that balance sheets are put to work, they too are recognising the benefits of pursuing an active sell-down strategy.
"Distribution is key. You need to be close to your investor base and be able to adjust lending parameters to match their needs. Otherwise you risk being caught out with big underwriting positions, or failing to win business in the first place through being insufficiently aggressive," said RBS' Hamilton.
This imperative is even stronger now that Europe's more flexible approach to pricing is making it harder for the take-and-hold commercial model to work on its own, especially for banks operating with restricted geographical scope. Banks that fail to make distribution a priority may find themselves confined to the mid-market. "There is still room for the old 'take-and-hold' model, but it is more likely to develop into a club-driven operation focusing on deals of €100m or less. We could see the development of two distinct markets," Hamilton said.
With increased distribution comes increased trading, particularly as many new investors work on a mark-to-market basis. That is not to say that banks must make markets in every deal, but each serious primary player must now offer two-way markets at least in their own deals. However, as the number of primary buyouts has dwindled, a fully functioning secondary platform has proved to have certain distinct advantages, as the recent quick-fire recapitalisation of the Apax investment Panrico demonstrates.
"Panrico was already highly leveraged during the original buyout", said Gilday at Goldman Sachs, which jointly led the new deal with Credit Suisse and ING. "The deal's performance in the secondary market was key to judging the timing and viability of the recapitalisation."
This intelligence allowed the leads to bring the company back to the market just over six months after the original closed in November 2005. Judging by the current slow timetable involved in primary deal flow, the ability to identify and support recycled deals in this manner is especially important to sponsors, for whom a regular supply of transactions is vital to meeting their return targets. This is especially important now that recapitalisations are themselves both harder to come by and harder to execute.
"The recapitalisation game has changed," said Richard Howell, co-head of leveraged finance at Lehman Brothers. "The low-hanging fruit that characterised much of last year's deal flow consisted of [more conservatively leveraged] deals from 2002 or 2003. This year's recaps are from deals struck in late 2004 or 2005, which were already highly leveraged. This is making investors more cautious about re-leveraging and giving early returns to the equity."
While Panrico's timetable may have been exceptional, the average time to recapitalise has been dropping, with many deals now recapitalised after about 18 months. This has led to a spate of add-on syndications that avoid the need for full recapitalisations. Headline deals for Brenntag, Saga, Weetabix and Rexel all opted for the add-on route this year. While this may be good news for investors who can roll their commitments into the new deal without the loss of income that a full-blown recap would entail, some commentators view this trend as another indicator of the top of the cycle, caused by sponsors squeezing the last few drops of debt out of an investor base that is already familiar with the credit, and would rather recommit its cash than start over with a more risky alternative.
With the record for leverage more than nine times earnings, the question of whether the market is at the top of its cycle is becoming academic. The pertinent question now is how long the market can stay there.
"Leverage feels like it has started to plateau. Banks are not compelled to invest and consequently the tougher pro-rata tranches have had a constraining effect. With the exception of a few sectors, we are no longer seeing leaps of half a turn of leverage at a time," said Lehman Brothers' Howell.
At the same time, default rates remain low, and inflation, especially in the US, no longer appears to be the beast it was six months ago. Most importantly, the global liquidity that got the market to its current state appears stable.
"For a while US loan yields were significantly tighter than Europe, making European deals attractive on a relative value basis. While the US re-pricing has now eroded this differential, the fact that most US investors have established dedicated euro CLOs means the effect on liquidity has been marginal", said Howell.
As long as no event-driven shocks hit the market, bankers will be hoping that increasing price discipline combined with liquidity getting smarter will produce a soft landing.