Leveraged Finance: Europe looks to US
The European leveraged loan market had a steady, but unspectacular, 2006 in terms of volumes. However, things have been much more exciting in terms of trends and developments and bankers have spent much of their times comparing the European market with its US counterpart. Nachum Kaplan reports.
The three main issues that have prompted comparisons with the US are deal size, US-style repricings and covenant light (which will be examined in another story in this report).
Deal size basically means that deals are getting bigger across both sides of the Atlantic but not to the same extent in Europe as in the US. When Danish telecom incumbent TDC was bought out for US$15bn in mid-2006, European bankers believed that the era of the mega-jumbo had arrived and that it was only a matter of time before a €30bn-€40bn deal was done in Europe.
However, it did not quite work out like that. It has taken almost nine months for the next true jumbo to happen, which is the £11bn buyout of UK retailer and pharmacy chain Alliance Boots.
This deal easily eclipses TDC as Europe's biggest buyout but it has been a long time coming and is still only half as big as the deals being done in the US, where utility TXU has been ought out in a US$45bn transaction and Equity Office Partners in a US$38.3bn deal.
That US deals should produce such large transactions is less surprising than the fact that Europe is yet to produce one, because the conventional wisdom is that the European market can finance bigger deals than the US market.
The US market is fund-driven, with institutional investors providing about 75% of the debt for any given deal. In Europe, the split is 50/50 and given that banks can write much bigger tickets than funds can, there should be more liquidity for deals in Europe than the US.
European leveraged loan banks reckon that €20bn–€25bn can be raised from the European loan market for the right deal, while about €10bn could be raised from the high-yield bond market. Throw in a €10bn equity cheque and you have the necessary financing for a mega jumbo.
Kristian Orssten, head of loan debt capital markets at JPMorgan, said that it was only a matter of time before such a deal happened in Europe. "Jumbo deals can get done in Europe – TDC set the ball rolling last year. There's nothing holding people back; it's just a question of finding the right deal with the right story. We are seeing several record-setting jumbo deals in the US and it's just a question of time before we see more deals in Europe. The market desperately needs some jumbo deals that will soak up some of the enormous liquidity that currently exists across all asset classes."
One reason that Europe is lagging when it comes to mega jumbos LBOs is that doing deals in Europe was politically and legally more complicated. "Europe is politically more complex and jurisdictional tax regimes have to be favourable for these deals to work," said Orssten. "The equity cheques are very large but with abundant private equity liquidity and the increasingly common phenomena of equity syndicates, this is no longer an obstacle."
One factor adding to the complexity of such large deals in Europe is that almost any deal of that size would be a public-to-private transaction and that is where politics often becomes a factor. "Some of the assets best suited to a large buyout are utility and telecoms assets, and they are often seen as extensions of the state in Europe, especially Continental Europe, and that can make things tricky," said the head of loans syndicate at a European bank.
Europe goes Americana
However, if the European market lags the US market when it comes to deal size, it is catching up very quickly when it comes to other US norms, and that is especially true when it comes to European borrowers doing US-style repricings, which involve pricing being lowered but not equity being taken out, are new.
Firth Rixon's £430m deal, which Lehman Brothers arranged, was the first such transaction in Europe. Firth Rixon's repricing involved the margins on the B, C and revolving tranches being reduced by 25bp, the second-lien tranche by 37.5bp and the mezzanine by 100bp. The repricing received a 100% positive response, allaying any fears that the European market would not accept a pure repricing.
A string of similar deals followed. Swedish cable operator Com Hem, for example, came with an add-on and repricing in which 25bp was taken off the margins on the A, B, C, revolving and capex tranches with a hefty 75bp taken off the second-lien pricing. Danish telecoms company and subject of Europe's largest buyout TDC repriced its €8.5bn loan and shaved 37.5bp off tranche A, 50bp off tranche B and 75bp off tranche C. French soft drinks group Orangina, likewise, returned with a €1.44bn repricing, in which 25bp was taken off the term loan A, the revolver and the restructuring facility, 12.5bp off the B and C tranches and 50bp off the second-lien tranche.
Pricing is falling so quickly in the European leveraged loan market that any delay between a deal being mandated and then launching can result in a mispricing. Downward flex has become the main mechanism in Europe to deal with this.
Pure repricings make sense because they address a slightly different situation, namely when sharply falling pricing leaves a deal looking overpriced just a few months after syndication is completed.
Deep liquidity has meant that recapitalisations have been happening sooner than ever before but pricing is now falling so quickly that it offers sponsors a chance to cheapen the capital structure if they are not yet ready to recapitalise and take equity out of the deal.
Repricings also illustrate the growing importance of the secondary loan market in Europe. Many leveraged names are consistently trading in a 101 or even 101-1/2 context, which is a clear invitation for sponsors to seek a downward repricing. The fact that most leveraged loans break one or two points above par only adds to the case for repricings.
The influx of US institutional investors into Europe and the convergence in the US and European investor base is also driving the trend for it has allowed sponsors on European deals to adopt US-style repricings with almost no pushback from the market.
This is partly because the market is so liquid and investors are so desperate to put their money to work that they will accept lower pricing but it is also because the converging investor base means that there is almost no education process required to get lenders to accept pre-repricings.
However, the big danger in all of this is that repricings become purely a function of liquidity, with sponsors opportunistically tapping the market for better terms, rather than a function of improved credit quality. It is hard to argue with the notion that pricing should reflect risk rather than just liquidity.
"Repricings make sense to investors and sponsors alike when there has been a tangible improvement in the underlying credit through deleveraging and/or strong trading numbers," said Chris Baines, managing director, European leveraged capital markets, at SG. "In this sense, repricings are similar to recapitalisations: they are a reward for performance."
But while European bankers may be importing US technology, they are putting their own twist on things to suit local circumstances. And given that circumstances that warrant repricings and recapitalisation may be similar, many European names are opting for deals that are a hybrid of the US repricing and the traditional European recapitalisation. In other words, pricing is being cut and equity is being taken to fund a dividend.
This is happening on deals that are probably ready to be recapitalised but where the sponsor also recognises that the market has moved and that there is an opportunity to cut funding costs.
A high-profile example of this is the Automobile Association's recapitalisation and repricing of its £1.85bn leveraged financing, through Barclays. The deal will turn the financing into an all-senior transaction with the mezzanine and second-lien debt being taken out and the amount added to the B loan. Additionally, pricing on the A and B tranches has been cut by 25bp, while pricing on the C loan has been lowered 50bp. Lenders are offered a 15bp waiver fee.
Towards the end of 2006 many bankers said that leverage had risen, equity contributions had fallen and repayment structures had become so back-ended that things could not really get much more aggressive.
Numericable's structural flex, through BNP Paribas, got the ball rolling early in the year and began the trend of removing subordinated debt from capital structures. Downward flex – on pricing and structures – has become standard on oversubscribed deals and now repricings are the order of the day.
Bankers seem to have learnt their lesson about making predictions, however. "I would like to be able to tell you that structures and pricing cannot get any more aggressive," said one UK banker. "Realistically, however, the past 18 months has taught us that there is no end of ways in which pricing and structures can be tightened."