European Leveraged Finance Roundtable 2007: Part 3
IFR: Assuming a buyout of a €1bn is possible, in terms of leverage what structure is now required?
Nick Jansa: It is impossible to say. You could find deals ranging what from five to 12 times in the bull market. You just look at everything on a case by case basis. It is impossible to say things have moved by one turn, two turns or three turns. It entirely depends on what the individual credit is and what you think is a very, very safe investment for an institutional investor or for a bank.
John Foy: I think that is right, and I think we can't get away from this point of selectivity. If you only have a finite amount of capital to use, whilst the markets remain closed you are going to remain very, very selective. To be fair, from our perspective we want to get leverage down as much as we can, we are going to want the highest price we can and we're going to want the covenants as tight as the financiers agree to.
Charlotte Conlan: I think from a structural point of view, one thing you will see that is different is in terms of the type of products that go into the capital structure. Second lien and the PIK market have disappeared, so you are back into a senior and mez structure for the vast majority of deals.
John Foy: And to be frank, second lien was a sort of demand-push rather than a demand-pull. It was driven by trying to get higher prices. There was a nice little market which started out initially with the hedge funds buying this paper, and as we got into this feverish bid for assets scenario over the last 12 to 18 months, everyone was just to trying to get hold of whatever bits of paper they possibly could. I think from our perspective clearly we preferred just to have senior and mezzanine. That is what we preferred because in terms of risk-reward that is what we were trying to achieve.
People are talking about a permanent market shift, but the market is always cyclical. Clearly there is a liquidity crunch that is driving the market right now, but markets bounce back. Now, I don't think it is going to be an immediate U-turn. I think it is going to be much softer and a much longer period. I hate to say it is going to be permanent and we have this senior and mez structure for good, because out here in two years' time, or whatever the period is, I can foresee the market getting back, not quite as frothy as it was, but I can certainly see the volumes picking up rapidly.
IFR: What does this mean for covenant-lite?
David Slade: In terms of structures, if you think about the history, covenant-lite has been around before. DLJ was very active in covenant-lite in the late 90s in the US before the downturn at the turn of the millennium and it all went away. If you look at something like covenant-lite, the point that Eric was making is correct – for a high-yield investor covenant-lite on senior is absolutely fine as long as the pricing is correct, because all I am doing is moving up the capital structure. I basically have the same covenant package that I had as a subordinated lender, so I am going to be very happy lending at senior provided the pricing is correct. And there will be deals or businesses which are very stable in nature where the requirements for financial covenants are not as strong as for a cyclical business.
The problem was that there was the fundamental conflict with a lot of sponsors of companies because it was those very cyclical companies that sponsors were saying we don't want financial covenants for. If you get a semiconductor business which is extremely volatile, sponsors would rather not have a covenant which is going to trip simply on one quarter's performance. But those are exactly the deals where lenders want the financial covenants because they are so volatile.
We still have investors saying: "look, it is very difficult right now to have covenant-lite deals because of all the publicity they have received". But there will be very stable businesses where, in theory, provided the pricing and the other terms are right, it makes perfect sense. But you have got to be aligned in terms of the type of the business, the sponsors and the lenders, in terms of whether that structure makes sense.
So I think a lot of the structures and prices that we had will come back. It will not be as frothy as it was. That froth will be taken off. But I think, fundamentally, the demand and the attraction of leverage loans and the various different parts of the structure remain there. I think people are a bit more sanguine now about the volatility.
IFR: Just on that structural issue, the other party to the structures are the sponsors and there was a suggestion in June/July that they were being very bullheaded about holding on to the gains they had made in the last six months. How is that conversation now?
David Slade: I think there is a range of how sponsors are reacting. Some are being very amenable, while some are being very hard-nosed. You know, the argument at the extreme end is: "an underwriter is an underwriter. You, as arranging banks have been making money for old rope in terms of underwriting fees over the last couple of years. That is what you get paid for – to call the market – and we don't have a back-to-back agreement with the seller of the business that if the market changes, we could change. So why should we as the sponsor or the company take all of the pain?"
There is a degree of disingenuousness with that approach, because everybody has benefited from the bull market, including sponsors, in terms of the structures they have managed to get and the prices they have managed to achieve. So it is difficult for them to argue that it is only the banks that have benefited from this. And I think a number of sponsors are being more cooperative in terms of saying, "what changes can you make?".
You can come up with changes to documentation or issues which don't fundamentally affect their IRRs. That is clearly an easier conversation than simply saying, "I would quite like to take out two turns of leverage, please, and can you put equity and can you double the pricing". As you can imagine that is a difficult conversation. But I think it requires a taking of the medicine right the way down the chain.
Eric Capp: The discussion also for sponsors is what degree of flexibility they want in their capital structures as they move forward with these investments. Clearly, sponsors who bought companies over the last six to 12 months bought them at very high purchase price multiples funded by very high levels of debt. If you think purchase price multiples are ultimately going to be lower over the course of the next couple of years that means they are going to have to work harder on their equity than they would have had to otherwise.
In that respect, they may need more cooperation with their debt investors to do acquisitions, change strategy, whereas before companies could be more in maintenance mode. They may have to work a lot harder at having the cooperation of lenders. It is important if they need to work harder to get the equity to work for their investors.
So the argument would be that some flexibility in making sure that deals get partially sold – they are trading a little bit better in the secondary market and are not as heavily concentrated in the hands of a small number of investors – is probably better in creating long-term value for sponsors than having completely stuck positions.
If you say a sponsor's going to give up some of its gains, gains are purely a function of supply and demand. When a sponsor wants to finance a deal and there are ten banks beating down their door willing to give each a quarter turn more than the other one, it is easy to set a precedent.
But when liquidity is not as high and investors, more importantly, are demanding some features that they had a year ago or two ago – and by the way, sponsors made very good equity returns on investments with those futures in the debt packages – sponsors will probably have to tighten some of those features. And you know, as I said, they made very good money on older investments with the same sort of restrictions in their debt packages.
IFR: So is it doom and gloom for the end of the year? Are we even talking about the end of the year? In terms of the outlook, do we have to look quite a bit further than that just to see our way clear to the market making some recovery?
Nick Jansa: I think it is evolving. In July everybody thought it would be okay in August. Now we are in September, everybody is saying it is probably the end of the year.
I think in two to three weeks we would know what the more realistic timeframe is, but I think everybody in private equity has accepted that this year is more or less closed to any substantial new business. Everybody hopes to do something, but it is not going to happen in the next few weeks. Everybody's hoping they could work through as much of the pipeline in the next few months as they possibly can.
But nobody knows how much is going to be worked through yet or what the external events are going to be in the next three to four weeks. Therefore, no one's actually willing to put any prediction on it other than you really are not going to see a return to normality until 2008. I think people are willing to say that. And what that normality is in 2008 no one is actually able to say yet.
David Slade: It is only because that is the next significant date. It was after the summer break, now it is January, but there is no evidence to show that come January it is all going to be back to normal – as I said, if you look at sub-prime mortgages it is the middle of next year. So I think Nick is absolutely right. Again, it is impossible to say when it will be back. I think the rest of this year will be very difficult.
I think there are a number of banks who are sitting on positions at the moment who, as the year-end comes closer, are going to feel under more pressure to sell. I think with the number of banks there are larger fires to fight elsewhere, whether it is US leverage, whether it is sub-prime, SIVs or whatever it may be. But I am sure more selling pressure will come in terms of the overhung positions. And I think the rest of this year is going to be largely about trying to move some of this backlog. I agree with what Charlotte said earlier, I think it is going to get worse before it gets better. I think there is a limited pool of liquidity at the moment that is going to get used up and then you are going to be back to square one to a certain extent.
Eric Capp: We are going to get a lot of information over the next three months. We are going to see deals restructured, negotiated and then launched into the market which will do their thing: they may get sold, they may get partially sold, they may not get sold. We will be having quarter ends, we will see hedge fund redemptions, we will be able to more accurately measure the amount of liquidity which is in the secondary market as well as the primary market. So the data that we have to make decisions will improve over the course of the next three or four months.
Now, the conclusions may not be any different from what we see today, but the data that we have to make underwriting decisions or to make investment decisions will improve and we will see where that takes us. But I think just that process of getting some sort of information out there, and it may not be clarity, but getting information out into the marketplace and going through price discovery, going through negotiations, getting economic data out of the way, that is pretty important because to a certain extent we are in a little bit of a vacuum and there is a lot of conjecture about what might happen.
I think everyone has pretty similar views, but I think just the uncovering as we go through the fall of all this information will help all the participants, including the sponsors. Hopefully the sellers of businesses take a view which will result in increased deal activity and that may be in first quarter, the second quarter, or in the back half of the year.
David Slade: Yes, I think it is about calling the bottom of the market. That is what it is going to require people to do. So you are going to need a period of time when it doesn't necessarily go up, but it just doesn't go down anymore, and you have an element of stability. When the market pops up, is it a dead cat bounce? If the thing comes up it then is going to go down again? So you always need that period of stability at the bottom of the market. I think a number of investors will miss that because they are going to need to be so certain that things are getting better that it is only when it really starts coming back up again that they're going to start buying.
Nick Jansa: The positive from Europe is that this pipeline is diversified among a large number of banks, as opposed to the US where it is more concentrated.
There is more stability inherently in the European market in terms of that sell-down of the forward pipeline than in the US. And that's what it gets back to, the point I made earlier, which is you may not see the jumbo deals happen early in Europe but there is going to be business because that risk is diversified heavily. It is not as diversified in the US, which is why so many investors have seen the US as a potential opportunity. And most of the banks in Europe, from what I can tell, are reasonably relaxed in terms of their forward pipeline. They would like to move it away, but they are not as exposed as some of the investment banks are in the US. That is a good news event for Europe because it means there is a little bit more stability and calm.
David Slade: There is more capacity and preparedness for people to sit on long positions in Europe, whereas in the US they have no alternative. If you have tens of billions of dollars of exposure, that needs to be shifted through the market. And I think most banks over here are in a position where they can be more sanguine about it. As I said, I do think there are going to be certain banks, as you get to the year-end, who are going to have to do some selling.
Eric Capp: I think the other issue is that the economic fundamentals in Europe to date have been better than the US. In the US there is uncertainty over the spillover from the housing market into consumption and how that may affect economic growth in the equity market. In Europe, we're actually in an improving picture as opposed to the US where there is uncertainty.
At the end of the day, when you are a leverage lender, fundamentals really drive so much and the companies generally are still performing pretty well and people's portfolio-risk is more diversified and there is probably less pressure to offload assets at year-end because earnings look better, which makes Europe probably more positive than the US, albeit the US mentality is to draw a line under it and move on, whereas the European mentality is to work it out over time. And that probably is to the advantage of banks who wish to do that, but net-net Europe is probably slightly better off in that respect.
IFR: Will the year end have a major impact in bank's ability to hold onto assets?
John Foy: CLOs have got a finite amount of cash and as there are no pre-payments, they are fairly full. We are in a pretty unique position with the life fund, which is worth £79bn. To be honest, we don't see any new pipeline coming up, but we actually do believe the banks will break, with some of the investments banks breaking ahead of the year-end. Therefore, that is a pot of capital that clearly we are going to deploy, hopefully as banks seek to clean and tidy up their balance sheets ahead of the year-end.
We are saying, no primary but there will be opportunities as banks are forced to look at their single exposure risk on their balance sheet on a market-to-market basis.
David Slade: We will not be talking much about new deals until we work through the overhang. It has to be faced.
There are certainly banks who are very comfortable about the positions that they are holding and will wait for better market conditions. But the problem is it is impossible to say when those market conditions are going to come back. So if you were taking a three-month time horizon and you were confident that, come January, the market would be back, it is a much easier decision to take than the fact that you are just looking into a load of murk at the moment and when is it really going to come back, and I think that is the thing.
As time moves on and there isn't necessarily any glaringly positive news, I think the pressure is then going to be: come on, we are not just going to sit on this forever, we need to start reducing our position. I think as the money comes back, there are some glimmers of good news. For example, last week, I was told by a middle-ranking CLO they have just been offered a warehouse loan. As we said, I think the message is getting around that the loans market has been heavily oversold, and there are some very good opportunities to invest right now. And you have seen in the press a lot of these funds being raised.
So you can have all the discussions about relative value and the fact that it is small compared to the overhang, but it is a very, very good time to invest if you have the courage to do it and if you are prepared to ride the couple of bumps in the road that will probably happen and run the risk that it may go down by a point or a point and a half.
So as those warehouses or investors come along and go to people like John and say, "look, I want you to invest this money for me", I think that will help. Any money, any liquidity coming into the market helps. I think it is a little bit like when you are trying to grow stuff in the garden. What you don't want to do is, when you see a shoot coming through, you get a bucket of water and pour it on because you say, let it grow. So it is going to require discipline on the part of the investor, and frankly, on the part of the arranging bank, if you like, to nurture it and to make sure you gain some confidence.
That is as much what we need as anything else, just confidence and the feeling that not everything you throw out there is going to get thrown back into your face. And I think once you get those little shoots of performance, that creates a bit of confidence – even if it is on a bilateral basis – that people are willing to come back and do it.
Charlotte Conlan: I agree. I think we all have very similar opinions on what the next few months are going to be like, and it is going to be a few months and it is going to be bit by bit, gentle steps. Confidence is a big thing. There is no confidence anywhere in the market from anybody at the moment. And it will take time and as you get rid of a little bit of one deal, so that means an arranging bank's underwriting is reduced a little bit. Maybe that takes a little bit of pressure off.
But really you need John and his fellow fund investors to come back to get anywhere near where we were before. And what is normality? We talked about the return to normality. I don't think anybody here will want to guess what is going to be the new normality, whenever that may be. It will just be different, because we have all learnt an enormous amount in the last two months.
Normal, going forward, will be different from whatever normal was historically because this has been quite a shock for arrangers and investors alike.