Sunday, 16 December 2018

Germany 2007 - The Promised Land

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Germany has long been considered the promised land when it comes to LBOs. The market is small relative to its economy and therefore chould have huge potential for growth. And with European leveraged finance booming in general, there is no reason Germany cannot live up to its promise – unless the LBO market crashes first. Nachum Kaplan reports.

German LBO volumes have risen markedly over the past three years. In 2005, 21 German leveraged loans worth US$11.23bn were booked, according to data from Thomson Financial. This rocketed to 34 deals worth US$20.97bn in 2006, and 2007 has started with a bang – seven deals worth US$3.32bn have already been booked.

Although this rise partly reflects a pan-European expansion in leveraged finance, it does provide definite cause for optimism, especially as the German LBO market is less developed than in much of the rest of Western Europe.

The main reasons that Germany lags the UK and France as an LBO market are cultural. Private equity houses are seen as asset strippers rather than agents of growth and the LBO as a concept is viewed as the antithesis of Germany's traditional corporatism.

"In Germany there has been a natural conservatism towards LBOs," said Chris Day, head of leveraged finance at Commerzbank. "There has been a natural conservatism towards LBOs. But there's been a gradual build-up that has now turned into good deal flow. The LBO concept has now filtered its way into the mindset of Mittelstand owners. Many of the Mittelstand businesses have reached a point where they need access to additional external capital and expertise. It's the internationalisation of German industry.

"In terms of LBO activity, much of Europe is further down the road than Germany as a percentage of GDP and potential, so there is a lot of room for growth. There has been steady growth in terms of number of deals but rapid growth in terms in the size and value of deals."

The main reason that Germany has been thought to have big potential as an LBO market is first and foremost the size of its economy, which is the largest in Europe. Beyond that, however, it is the number of conglomerates and family-owned business that was seen as creating the potential.

It is very much the vogue these days for conglomerates to trim down, focus on core competencies and spin off underperforming assets or assets away from the core focus. This disposal process provides obvious targets for private equity buyers.

On the conglomerate side, the deal flow has already begun. The year kicked off with an excellent example in the form of KION's €3.5bn leveraged financing, which is the largest LBO from Germany. KION was the materials-handling unit of German industrial gases giant Linde, which sold the unit to sponsors KKR and Goldman Sachs Capital Partners for €4bn.

Bookrunners Barclays Capital, Credit Suisse, Goldman Sachs, Unicredit, Lehman Brothers, Mizuho Corporate Bank and UniCredito arranged the €3.3bn loan that supported the buyout. The financing was hugely oversubscribed and a testimony to the buoyant European market and of the level of interest in Germany. The leads responded to the oversubscription with a heavy structural and pricing flex.

The addition of €150m to each of the B and C tranches replaced the deal's €300m 10-year mezzanine loan, which made the structure far more aggressive by removing the mezzanine buffer between the senior debt and the equity. Additionally, pricing on the B and C tranches was cut by 25bp and 50bp respectively, while the margin on the second lien debt will also be lowered by 50bp.

Post-flex, the structure comprises a €900m eight-year term loan B paying 225bp over Euribor, a €900m nine-year term loan C paying 250bp, a €200m nine and a half year term loan D (second lien) at 400bp, a €250m 18-month leasing bridge at 150bp, a €350m 18-month receivables bridge at 150bp, a €400m seven-year capex line at 200bp, and a €300m seven-year revolver at 200bp.

When it comes to family-owned businesses, it is less clear that the deals will flow. The traditional hypothesis is that many family-owned businesses will eventually face the question of what to do with their businesses should family members be unwilling or unable to run the business in the next generation. But for all the talk over the years about such deals, not many have ever come to fruition.

"Over the years there have been expectations of deal flow from companies with family succession issues, but there was never going to be the huge deal flow from this source that some had prophesised," said Commerzbank's Day. "As significant part of deal flow will continue to come from conglomerates disposing of assets."

Threats on the horizon

There are good reasons to think that the German LBO market can keep growing, but there are threats to that scenario. The biggest threat is not from Germany's conservative business culture or from its private equity-wary politicians but rather from the possibility that the LBO market will crash before the German market achieves lift-off.

After all, the European leveraged loan market has been booming for several years now and there are clear signs of froth. Indeed, almost all the signs that the market is at or near its peak are there. Leverage is sky high, equity contributions are low, covenants are light, pricing is falling and structures are getting more and more aggressive.

The two biggest developments in the European leveraged loan market this year are downward pricing flex becoming an almost standard occurrence of oversubscribed leveraged loans and the structural flexing of loans to replace oversubscribed subordinated debt with senior debt, such as happened on the KION transaction

The first of these developments is not really a cause for concern because it means greater pricing flexibility, and more specifically pricing that reflects risk more accurately, and is therefore a positive development for the once-staid European market. In fact, flexible pricing is a sign of an increasingly mature and sophisticated market.

The second development, however, is of far greater cause for concern as it represents a move away from sensible structures in that senior lenders have a degree of protection in the event of default because of the subordinated debt, usually mezzanine, beneath them in the capital structure.

Furthermore, covenants have eroded to such an extent that it is now possible for a company to be underperforming seriously without triggering any covenants and alerting any of its lenders. In the Netherlands, World Directories has already found huge success with Europe's first covenant-light deal, a €1.161bn transaction, and there are expectations that more such deals will follow in all European jurisdictions, including Germany.

This raises the questions of to what extent is the German market distinct from other European markets and to what extent it is beholden to wider European trends.

The German market is unquestionably distinct in that its level of development is not comparable to the French or UK markets and therefore has more room for growth. However, it unquestionably part of the wider European market in the sense that it is hard to imagine lenders being keen on Europe but worried about Germany, or equally wary of Europe but keen on Germany. This is especially true for institutional investors from the US who are more familiar with the ratings-driven US market than with the traditionally credit-oriented European market.

"It is only the most sophisticated investor that really draws a line under Germany as a specific market within Europe," said one leveraged loan distributor at a German bank.

"Most investors, especially institutional investors, make a decision to invest in Europe or not invest in Europe without looking at specific countries, with the exception of highly risky markets, but then you're talking more about emerging market risk than leveraged risk."

This means that for all of its potential, the German market will not be spared in any wider European correction. Almost nobody is willing to bet on when that correction will come, or if it will be severe enough to be called a crash, but most players agree that the current market looks toppy.

The irony is that the more aggressively banks and institutional investors lend money, the quicker the German market will develop, but at the same time the more quickly any future correction is likely to come.

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