Germany 2006 A back-ended year
Germany has long been heralded as Europe’s most promising market for leveraged finance, yet for various reasons the actual deal flow never quite reflects its potential. Despite a slow start to the year, market participants remain convinced that the increasingly sophisticated German market is on track to exceed its 2005 levels. Adrian Simpson reports.
There were fewer jumbo deals and a higher proportion of deals between €500 and €1bn in 2005. Excluding real estate portfolio transactions, this trend was even more obvious. “In the first months of 2006 the number of both large and mid-sized deals has been lower, although the transaction services teams at the large accountancy firms are very busy on the due diligence and spin-off advisory sides “, said Jochen Koenig, managing director and head of leveraged finance Germany at RBS. “I am very optimistic that the pipeline will catch up."
Koenig’s confidence is well-founded for two reasons. Firstly, as the leveraged market has derived a larger proportion of its volume from recapitalisations over the last two years, Germany has been at a disadvantage as its universe of existing LBOs was lower to start with. Many of its mid-sized corporates continue to rely on the family-run model, using bilateral lending via the relationship bank route as their main means of finance. Now that Basel II is really making its presence felt and the state guarantee mechanism has been removed, this financing model has been consigned to the past.
As cheap money has dried up, companies are turning towards the capital markets at an accelerating pace and are becoming more amenable to the sponsor driven, Anglo-Saxon model of business.
Secondly, Germany’s largest corporates are now at the end of a long period of rationalisation. With lighter balance sheets and cheap debt on tap, the German market is at the forefront of Europe’s current M&A resurgence. While this may bring some disadvantages for the private equity community, there are also some big wins to be made.
“The return of trade buyers equates to a lower hit rate for private equity, although we are not too worried as this re-entry very often creates by-products for the market like asset strips," said Claus Peter, head of leveraged finance for Germany at SG: RBS's Koenig agrees: “When trade buyer activity is strong, sponsors tend to refocus their attention on the exit process. The increased trade activity also creates further buyout opportunities as companies have to dispose of existing assets, either to satisfy anti-trust authorities or to finance cash offers.“
While the expected drop-off in refinancing activity is frequently attributed to the fact that deals have already been leveraged up to their limits and structures are stretched to the maximum, other factors such as the cost of due diligence and advisory work and the management time involved also play a role. Cleary this year's focus is on fresh deal ideas, which is also the preferred objective for sponsors.
Despite the upbeat tone, Germany still has a number of hurdles to overcome before this flow of new deals fully materialises. While political resistance to sponsors and their funders has received plenty of attention in the past year as a result of comments by politician Franz Muentefering, who infamously referred to hedge funds and their ilk as ’locusts’, there are some other, more subtle issues that could act as a brake on LBO activity.
“There are some legal uncertainties remaining [in Germany], including the treatment of minority shareholders [by the courts]. A high settlement may be all right for a corporate, but it can destroy the IRR for a private equity house. The claims process can also take years. Hopefully this issue will not delay the next stage of the development of private equity in Germany," said Koenig.
Ironically, although the sponsors were quick to dismiss Muentefering’s comments as political manoeuvring, they themselves regard their new liquidity sources with suspicion. As SG‘s Peter says: “There is an increased demand from private equity sponsors to shortlist debt investors or to be actively involved in the selection of debt investors before the syndication is launched. Not everyone gets an invitation. On the other hand, there is a very transparent world market for larger deals now and hedge funds and other debt investors buy into deals in the secondary market. Companies and private equity funds have to accept that the world has changed.”
Anyone who is still in any doubt about how much the market has changed need only look at some of the deals that are now being brought to market compared to only one year ago. “We can expect to see a lot more jumbo LBOs. Just a few years ago a deal like TDC would be unthinkable. Private equity has been raising more money than ever before, especially in Europe, and Germany has been a major area of their focus. German companies are seen as being well run and possibly over-invested, which provides the opportunity for rationalisation," said Mathew Cestar, head of high yield at Credit Suisse.”
To get deals of this size away requires strong appetite from institutions. As these more nimble players can respond quickly and play across any part of the capital structure, it is likely that there will be a increased convergence between the products used to finance deals. It is also likely to continue to push debt towards higher yielding structures.
"Some deals have struggled recently on the pro-rata pieces as investors tend to invest in higher yielding parts of the debt structure. High leverage levels are certainly supporting this trend." said Kim Christian Koehler, head of leveraged finance Germany at Merrill Lynch. "Liquidity for this part of the structure is actually stagnating – if not decreasing. While the market is not yet ready for the 100% institutional deal, ever increasing demand from CDOs, CLOs and hedge funds is focusing structures on the institutional tranches. This is more like the US model."
SG’s Peter echoes this view: “The need to maintain the fixed charge cover ratio in deals with high leverage multiples creates a need for more non-amortising tranches, as seen in the historical growth rates in B/C tranches, second lien, mezzanine and other high-yield products“, he said.
The German market should continue to provide a strong flow of high-yield corporate issuance, particularly as rates are around 40-year lows. The fact that the European Central Bank has raised rates twice in recent months, with a further rise of up to 75bp expected before the end of the year, provides companies with a good incentive to capture attractive rates now.
While some of the potential candidates will no doubt take the mezzanine route – which is putting severe pressure on the high-yield market – the flexibility of the high-yield product means it carries advantages in certain situations. Fresenius's €1bn senior notes issue (Ba2/BB+), backing its acquisition of fellow healthcare business Helios Kliniken and led by Credit Suisse and Morgan Stanley was a good example.
"Fresenius achieved bank-like pricing for a long-dated bond instrument without the restrictive covenants," said Cestar. The corporate deal comprised a €500m seven-year fixed tranche carrying a 5% coupon and a 5.5% €500m 10-year non-call five tranche.
High-yield's less onerous terms may also bring deal flow from the cable market, where heavy capital expenditure requirements associated with network upgrades is causing bank covenants to creak. So far KDG and IESY have both been linked with floating-rate issues as a way of freeing up their balance sheets, although the most recent indications are that both companies have managed to extract the required concessions from their loan bankers to tap the markets on the senior side.
Nevertheless, in a rising rate environment, investors demand credit risk rather than interest-rate risk, and with spreads tight and weighted averages at or near call levels, the outlook for floating-rate instruments in such cases appears positive.
But flexibility and price are not the only advantages that are boosting Germany’s high-yield issuance. As the lending base has become more diverse and sophisticated, high-yield has lost its pejorative ring, which has allowed more innovative products to come to market. In December, German travel and shipping company TUI demonstrated just how far this had come when it became the first non-investment-grade issuer to sell a hybrid bond last December.
The €1.3bn three-part deal, led by Deutsche Bank, Citigroup, RBS and HVB, comprised fixed and floating-rate notes as well as the €300m B+/B1 rated non-call seven (200bp step-up) hybrid, which was structured as perpetual subordinated fixed-to-floating rate bond. The deal attracted huge retail interest and was well supported on account of the 300bp extra the piece paid over its cash equivalents for only slightly more risk.
Other German companies taking advantage of the more risk-hungry investor base include small arms manufacturer Heckler and Koch, which priced a €100m non-call-one PIK loan in March. Hedge funds turned out in force to support the Merrill Lynch led seven-year deal, which pays 800bp over Euribor.
Other deals touted to come to market in the second quarter include a €500m bond backing the buyout of Europcar from its parent VW, which is being led by BNP Paribas, Calyon, Deutsche Bank and SG, and Kronos, which is likely to refinance its €375m 8.875% senior notes due 2009 via relationship bank Deutsche Bank.