Leveraged Finance: Investors regain clout
Hit by the recent disruptions in the global equity market and the domestic sub-prime market, the bullish US debt markets are showing early signs of softening. The effects have been lower trading levels and a less welcoming investor base both on the high-yield and bank debt sides of the market. The end-game is yet to be seen, but, one thing is certain: with uncertain fundamentals, investors are looking at deals more closely than before. Michelle Sierra Laffitte and Joy Ferguson report.
Volatility stemming from the global equity markets, concerns over a looming economic slowdown and uncertainty about the ultimate effects in the US economy of the sub-prime market mortgage and housing market has trickled down to both the high-yield and the loan market. This uncertainty is already affecting LBO-related deals both in the primary and secondary markets.
Leveraged investors have necessarily become more disciplined. This sentiment can be seen in the performance of recent high-yield issues in recent LBO transactions.
The change in sentiment is evident in the aftermarket as riskier LBOs have seen a less welcoming investor base. Reader's Digest's, for instance, priced a US$600m Caa1/CCC+ offering in February to fund the company's buyout by a group of private equity firms. The new 9.00% notes due 2017 have struggled in secondary, with bids seen at 96.50-97 in late March.
Digicel's Caa2-rated two-part offering, also part of a buyout financing, was down a few points from its par new issue price and Rite Aid's new 7.5% notes due 2017, used to fund an acquisition, traded down to 98.25–98.75 in late March.
Looking back a year or two ago, almost any leveraged buyout could get done on aggressive terms. Yet as investors witness several recent buyout financings trade poorly, there is a new sense of discipline in the market place. Strong credits will continue to perform well in the primary market, while weaker ones will have to pay up. Investors are using discretion.
The feeling has also trickled to the loan market, despite the seniority of loans and the increased security the asset class offers. Investors push for better terms. Issuers trying to reduce pricing or loosen terms have found it increasingly difficult.
This has affected both LBO and non-LBO related deals. Realogy faced considerable challenges when marketing its US$4.7bn bank debt deal. Ply Gem Industries, PETCO, Aramark are recent examples of ambitious repricings and covenant-striping amendment proposals that had to be moderated before getting done.
“People are realizing that loans are not risk-free investments,” said investor.
The market is certainly not as strong as it was a month ago. “There are people that looked at the market in January and February and were prepared to launch covenant-stripping amendments or repricing amendments that decided not to,” a banker at a top tier investment bank said. “The dialogue from capital markets to the client over the course of the last three days has been more cautious to clients that are doing opportunistic deals,” he said.
Such uncertainty has also translated into softer trading levels in the secondary market. The average price in the loan market has been fluctuating between 100.5-100.75 since the beginning of the year, a loan market strategist said. “At the bottom of the China news average bids went to 100.5,” he said.
But that doesn’t mean that the loan market is unappealing for issuers or investors. “There’s been pushback and spreads are a little bit wider but, just because spreads go back to more normal ranges and deals have two or three maintenance covenants, secured by liens on all assets, that doesn’t mean the world is coming to an end. It’s just a swing back of the pendulum to the more normal range of deal structure," said Jonathan Insull, portfolio manager at TCW Asset Management.
It’s all fundamentals
An increase in the cost of capital, would indeed have an undermining effect in company’s valuations thus affecting LBO multiples. But so far the increase in the cost of capital has only been in the margin at around 10bp. More than 10bps here and there, a decline in the growth of corporate earnings would actually hamper valuations.
“An increase in the cost of capital will have a dampening effect in valuations,” a private equity source said. “But, the biggest dampening effects in valuations are revenue growth, which is driven by GDP, and corporate earnings growth (which is driven by revenue growth and costs or operating leverage). I think those two things are bigger question marks at this point,” he said.
In that vein, pricing is less important for sponsors than one might believe. Even if spreads widen, they will still remain in a very attractive band. Since it tends to move around the margin and deals are pre-payable, pricing is not precisely a deal breaker. “If the sponsor figures out its return on investment the difference between a deal being priced at L+225 and L+300 doesn’t change the investment thesis,” the banker said.
More so, the sustainability of this current economic expansion is a critical factor. “Corporate earnings are not as good as they’ve been but are still coming in strong, so ultimately these fundamentals are more important than the technicals which include spreads,” the private equity investor said. “Earnings are still good but we are at the point where a lot of people are asking when we can expect an end to this current economic expansion, will the sub prime issues have a material negative effect on GDP.”
"The recent volatility in equity markets worldwide, certain sectoral weaknesses, such as sub-prime lending, and a consensus view among economists that economic growth and profitability will slow all indicate weaker corporate credit conditions, said David Hamilton, Moody's director of corporate default research.
Despite the evident signs of an economic slowdown, it is likely that it will take some time before the recent market disruptions actually trickle down to the way LBOs are structured and pitched. That is because there is so much liquidity in private equity and debt markets. “Have we started the change the way we pitch and structure LBO deals that haven’t come to market yet? The short answer is no,” the banker said.
The risk premium for lenders could increase, yet, as deals continue to be increasingly large, structures are expected to remain very competitive in order to appeal the last dollar of liquidity. “Because this business is very competitive and some of the assets that the sponsors are going out for are very attractive, we continue to pitch deals and we have deals that are prepared to come to market that are aggressively structured relative to the current market,” he said. “It’s just a question of whether or not we have enough wiggle room in our commitment letters to clear them.”
Not too much cutback
While prices are rising defaults are almost nowhere to be found. Moody's speculative-grade default rate ended February unchanged at 1.6%, the same rate as the previous two months. This is low by historical standards, but a climb is anticipated. Moody's predicts the default rate will rise to 2.7% by the end of 2007, rising to 3.2% by the end of February 2008. S&P showed a global default rate of 1.17% in February, with the US default rate coming in at 1.32%.
Even with default rates increasing, "There is still a lot of appetite for deals," Martin Fridson, publisher of Leveraged World. "Private equity firms are in a great position because they can do more loans or more bonds depending on the conditions. We're unlikely to see much cutback there."
Liquidity remains such that most leveraged buyout financings will find a home. Borrowing costs still remain low relatively speaking, and liquidity in the marketplace will allow for a number of upcoming buyouts to price with ease. The pipeline is indeed filling up.
For the first quarter of 2007 LBO volume in the US totaled US$93.1bn, up from US$45.5bn for the same period in 2006, according to data by Thomson Financial.
The US$45bn buyout of TXU Corp by KKR, Texas Pacific Group, Goldman Sachs, Lehman Brothers, Citigroup and Morgan Stanley is slated to be the largest buyout in history and is expected to be financed with US$7bn in high-yield bonds and roughly US$18bn in senior secured loans. Even if the market sours further, TXU will be an attractive investment.
In the end of the day, debt costs will rise and availability will decrease. But nobody knows when. “It all depends on fundamentals. We could see a steady tightening--or strong fundamentals could rally the markets as happened after Ford/GM downgrade in 2005 and equity market sell off in May/June of 2006,” the private equity investor said.