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Monday, 16 October 2017

Leveraged finance 2007

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Exciting and scary are the two words that best sum up global leveraged finance in 2007. The market is exciting because the deals are getting bigger and more complex and it is scary because the pricing is getting tighter and the financing structures more aggressive.

Deal size has been the most noticeable feature in leveraged finance with transactions getting bigger and bigger and with no company seeming too big to fall into the hands of private equity. The US has led the way with the US$45bn buyout of TXU but Europe has joined the party with the circa £11bn buyout of Alliance Boots, while in Australian the buyout of national carrier Qantas was valued at just over A$11bn.

The other big change is the institutionalisation of leveraged finance with institutional investors like CLOs, hedge funds and long-only accounts providing more and more of the debt that finances LBOs. Institutional investors account for about a quarter of lending to US LBOs, about 50% of the lending to European LBOs but only a fraction of lending to Asian LBOs, although there are signs that Asia beginning to follow the global trend.

Institutionalisation has changed the way LBO financings are structured – because institutional investors want different tranches to traditional bank lenders – but also because they enable bigger deals to be financed. More investors equals more liquidity which, in turn, equals the ability to finance larger deals. Combine this with record private equity fund raising, with as much as US$500bn tipped to be raised in 2007, and it is not hard to see why deals are getting bigger.

The US market, as the world's most mature leveraged finance market, is still the world's biggest market but the European market has truly come of age. European leveraged finance has morphed from a niche market as little as three or four years ago to one of the region's fastest growing, most dynamic and visible markets.

Asia is still some way behind but there is still plenty of action there. Australia is the clear standout and is the region's first leveraged finance market really to take off. Things are less clear cut elsewhere in Asia, however, where the obstacles to leveraged finance are almost as great as the potential. In India, regulations make in-bound transactions difficult to do

but also encourage outbound LBO financings. The Chinese market has been more disappointing with most deals still failing to get done, from both a transactional and syndication point of view.

All this rapid growth across the globe is good news but there are is also cause for caution. Deals are getting bigger but the financing structures supporting them are getting more aggressive and, in some cases, dangerously so.

Valuations are rising, equity contributions are falling, leverage levels are going up, subordinated debt is disappearing, covenants are eroding and amortisation structures are becoming increasingly back-ended. All these are signs that the market is near or nearing its peak and can go only one way – down.

These worrying developments are taking place against a backdrop of rising interest rates. Cheap debt, as much as anything else, is responsible for the global leveraged finance boom over the past five or six years. More expensive debt not only will make the financing of many deals unviable, it will also put strain on those companies that have been bought out and leveraged up and now having to repay that debt.

This is not to say that the market is necessarily in for a severe correction. There is much more liquidity around now than ever before, and pretty much right down the credit curve, so it really is possible to finance deals that would not have been possible just a few years ago.

The danger is that this liquidity will be abused and used to finance deals that just do not make sense. If common sense prevails and all parties eschew overly aggressive financings in favour of structures that genuinely make sense, the good times can keep rolling for some time yet. If greed gets the better of everyone, however, then today's threats could be tomorrow's losses.

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