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Tuesday, 17 October 2017

From boom to bust?

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The German leveraged finance market forms part of the mainstream of Western European activity. But what goes up must come down and a boom in good times has left it among the most obviously affected by the general downturn in demand for leveraged debt since July 2007. Donal O’Donovan and Solomon Teague report.

The experience of buyout financing in German in the aftermath of the credit crunch has been brutal. The value of buyouts announced fell from €13.8bn in the fourth quarter 2006 to less than €1bn in the same period in 2007. So far this year, just a handful of deals have been announced.

Poland and Turkey, which boast exceptional growth opportunities and local bank liquidity, and the Nordic market with its remarkably supportive banking sector, have managed at least to some extent to avoid the buyout slump. Germany has been less fortunate.

“German LBO deals cannot rely on the support of ‘house banks’,” said Werner Meier, a partner with law firm Cleary Gottlieb Steen & Hamilton. “Such relationships have tended to disappear for most mid-sized borrowers and were never there for sponsors. Post credit crunch that has meant the market has been less resilient. Key lender relationships are in London.”

Germany’s experience is actually closer to that of other core markets, like the UK and France, which it has increasingly come to resemble since interest rates rose to levels more indicative of the rest of the continent, removing access to ubiquitous cheap financing.

While precipitous, the fall in activity was from a level that was itself exceptional. The fourth quarter 2006 generated a remarkable string of record breaking deals, syndicated in the first half of 2007. Among them was a €7.9bn debt package backing the merger of ProSiebenSat.1 Media (P7S1) and SBS, a €3.3bn debt package backing the €5bn buyout of Kion and a €2.38bn LBO financing backing the €3bn buyout of Lafarge Roofing.

Despite their enormous size and complex structures each was flexed down in response to significant oversubscriptions. The consensus now is that it could be years before such deals are seen again. It is proving very hard to put the packages in place for multi-billion dollar buyout deals, said John Gripton, head of investment management for Europe at Capital Dynamics, a fund of private equity funds. The larger deals that require syndication and which previously attracted interest from a large number of banks are finding fewer willing participants, he said.

Compared to early 2007, the private equity industry in Germany has certainly weakened, noted Gripton. Yet looking at longer term historic pricing norms the industry is looking perfectly healthy. Last year saw a significant upward shift of prices, with debt hitting levels of 10 or 11 times Ebitda. Levels had previously remained consistent at around eight or nine times, Gripton said – levels currently being seen.

Reduced debt necessitates greater levels of equity, adversely affecting deal returns. But, like prices, returns have not fallen significantly below long-term trend levels. The 25%–30% returns typically being achieved by the first half of 2007 were arguably unsustainable, but Gripton projects returns over the coming 10 years to average 15%–20%, in line with the longer term returns traditionally achieved by private equity funds, though of course there is scope for volatility in the near term. “Debt is still relatively cheap,” he added.

Arguably, therefore, the credit crunch has helped bring private equity back to earth, requiring investors to rediscover the careful analysis to which opportunities were subjected a few years ago. The deals that are being done are using less leverage and higher ratios of equity to debt, Gripton said. Covenant lite deals are being replaced by deals that look more typical of what was being done a few years ago, with a tightening of the terms on the servicing of the debt. Repayments based on corporate earnings are less common, and amortising loans are making a comeback.

The renewed focus on credit quality means arrangers are simply not underwriting the kind of aggressively geared, tightly priced deals they might have been before the market turned. “The marginal deals will have difficulty in this market,” said Robert von Finckenstein of private equity firm European Capital. “It’s a much healthier environment, and we welcome it, along with the disappearance of covenant-lite. It’s a more lender-friendly environment.”

Yet Christof von Dryander of Cleary Gottlieb Steen & Hamilton said he is not convinced due diligence is as thorough as it was before the crunch, with good business sometimes suffering as much as the bad. “The jury is still out on that,” he said.

Size counts

“The German market remains reasonably active,” said Chris Day, head of leveraged finance at Commerzbank Corporates and Markets. “Deals are still feasible in the larger mid-cap segment, supported by demand from German-based bank investors and from abroad.” There is, in fact, a plentiful supply of mid-size deals, under the €500m mark, and it is largely the deals above this level, common in early 2007, that are becoming rarer.

In Germany, especially, this is fuelled by growing interest from the Mittelstand. Many such companies, established in the 1940s and 1950s, Gripton explained, are now facing succession issues as founders retire. Private equity is being used to finance consolidation where the inheritance has been divided among siblings.

Many of these same types of companies are using private equity financing to take their businesses global, Gripton said. In an increasingly globalised economy companies are faced with increasing competition, and growth can be a way of remaining competitive.

Sources indicated there are five or six deals from all capitalisations in the wider auto sector currently in the pipeline. Capital goods and manufacturing concerns also continue to attract sponsor attention.

Debt backing the buyout of German manufacturing concern Almatis was one of the first large deals successfully syndicated anywhere in Europe after the credit crunch. The handful of post credit crunch deals includes a significant number of German mid-cap transactions.

The Almatis deal highlights a number of features of the current German experience. Almatis is manufacturing business with a global presence, while sponsor Dubai International Capital is part of a wave of Gulf based funds targeting Western European assets. These characteristics are equally true of the buyout of PVC window-maker Profine by Bahrain’s Arcapita. Both deals are also secondary buyouts, with an existing investor group to rely on in syndication.

Margin adjustment

Syndication of the US$970m “new era” debt package for Almatis, which closed in December, set the template for an achievable sell down. With UBS coordinating and bookrunning the deal, alongside bookrunner Arab Banking Corp, it came with margins in line with market expectations: a seven-year term loan A paying 250bp over Libor, an eight-year term loan B paying 300bp and nine-year term loan C paying 350bp. Junior debt is split between a nine-and-a-half-year second lien facility paying 600bp, with mezzanine debt below that.

Higher margins are now typical, though we have yet to see a return to standard pricing, as can be seen in the €700m debt package backing the secondary buyout of SAG, a power plant builder and operator, for which Commerzbank, BNP Paribas and RBS ran the books. The facilities included a term loan A paying 225bp, a term loan B paying 275bp and term loan C paying 325bp. The deal again features a mezzanine loan, which was placed and underwritten by ICG.

Both deals reflect a reversion to conservative capital structures featuring larger A tranches, lower leverage and higher margins. The tick up in pricing and conservatism of capital structures is a reflection of the return to pre-eminence of bank investors. Deals also again typically feature a mezzanine tranche, in line with experience elsewhere.

This, noted Von Finckenstein, has benefited mezzanine funds, which in early 2007 were being excluded from many deals by eager bank syndicates. Now the lack of liquidity at the banks means mezzanine tranches are being placed with mezzanine funds, with the senior tranche syndicated by a smaller group of banks.

For funds that are not shackled with high levels of leverage, times are particularly good, Von Finckenstein said. European Capital is less than one time levered. The same is true of the banks: the big players before the credit crunch have generally been the hardest hit, allowing banks that were previously shut out of the market, and therefore had low leverage, to get in on the action. Some German Landesbanks, previously inactive in this sector, are now taking part in some of the mid market, sub-€500m deals.

Smaller and medium size deals, and those with moderate levels of leverage, are taking longer to complete now due to the extra due diligence being conducted by the lending banks. Day also noted a change in the overall syndication strategy. “It is now a club deal world, even to the extent that deals with a sole underwrite are being approached with a club deal mentality,” he said.

This also creates opportunities for private equity funds, which in some cases have seen their influence extended: a relatively small investment may wield a disproportionate level of influence because borrowers have such limited options for looking elsewhere for funds, said von Dryander.

Among the most interesting of these are minority investments in financial institutions: in many instances financial institutions’ funding requirements are beyond the capacities of private equity groups, but in others relatively small amounts of additional equity are urgently needed, giving private equity firms very interesting opportunities in banks they would not usually have, von Dryander added.

The flip side of the coin is that some of the investments made by private equity companies before the troubles began in the summer of 2007 have started experiencing problems. Many observers expect there to be a substantial increase in the rate of defaults as 2008 progresses. “Turmoil in the markets screws up their own internal calculations and forces them to decide whether to invest more, with the risk they will be throwing good money after bad,” said von Dryander.

Mid-market concentration

As the overall level of activity has fallen there has been a concentration of sponsor activity in the mid market, focusing a mix of arranging banks on the same narrowing field of activity. “The concentration of activity in the mid market does create a competitive climate between those arrangers that are still active,” said Day. “However, despite competition, neither sponsors nor arrangers want to end up with un-sellable deals, forcing arrangers to differentiate themselves based on their market insight and ability to add value by understanding the market, rather than offering aggressive leverage or margins.”

Perhaps unsurprisingly domestic arrangers say one result is that the edge on underwriting has shifted back in favour of those houses that can add value through local knowledge and market insight.

The market has also seen a number of add on deals, again relying to some extent on an existing investor group which can be accessed to create momentum in syndication. In January bookrunner Dresdner Kleinwort closed a €225.7m an add-on facility for Sports Group, which builds athletics surfaces. The deal, which closed oversubscribed, supported a planned acquisition in the US.

In February leads BNP Paribas and Goldman Sachs launched syndication of the €565m package backing TdF's buyout of Deutsche Telekom's Media & Broadcast unit. ABN AMRO, Calyon, Dexia and SG are also acting as bookrunners and MLAs.

The deal is the second element of a financing which also includes a €170m add-on at TdF level.

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