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Tuesday, 21 November 2017

Leveraged Finance Roundtable 2005: Transcript

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The past 18 months to two years has been an exciting time in the European leveraged loan market. The size of deals has increased, the breadth and type of participants has increased, structures have become more aggressive, pricing has become flexible, multiples have become high - some would say crazy - but basically it all seems to come down to one point, which is the huge amount of liquidity sloshing around the market.

IFR:This is what I would like to begin with. Everyone talks about liquidity but rarely do we touch upon where all this liquidity is coming from, and I thought I would put you on the spot for that one, Euan.

Euan Hamilton (Royal Bank of Scotland): Thank you! All of us would agree how crazy the multiples are. But we always find an excuse why our deal is not the crazy one.

In terms of where the liquidity is coming from - the hedge fund. It sits out there as a name, hedge fund, and there are so many different types of hedge funds. But these guys have money and are willing to put it to use. And Deutsche Bank and RBS and Goldman Sachs are going to make best use of that. They want something and we can provide it to them at a price. I suspect guys like us are not going to stop producing aggressive structures and multiples.

What is more distressing is what it is doing to things like documentation. If you look at a set of documents today, as opposed to three years ago, you would be concerned by how lax and loose they are.

They are really quite scarily loose, what the sponsors get away with. The document I negotiated last week is the starting point for next week's negotiation. That is where you start from and then they will squeeze something else out. I find that almost more worrying than the liquidity, because when things do start to go wrong, we will look at these documents and suddenly think - I cannot do anything.

IFR: You are losing the downside protection?

Hamilton: Yes, I am absolutely stuck in here with this deal.

Louis Gargour (RAB Capital): We were looking at PIK notes and what protection you are afforded and the conclusion we had come to was pretty much nothing.

We can get layered, we can have dividend streams, knock out, the sponsor can pay themselves first, and even an IPO does not trigger the redemption of PIK notes. Let us think about what PIK notes are: pay in kind, increasing liabilities, increasing leverage, and when we look at a deal, we think, how quickly can these guys de-leverage? Probably not as quickly as PIK notes accrete or increase. You are just waiting for something to happen, and we are not afforded much protection.

Deals are very different: you have to go through the documentation with a fine tooth comb to determine negative pledge and the covenants. We have insiders on some deals, because we have a loan fund, and in those cases a better idea of the management accounts. But you are right. You have less protection and we certainly have less protection.

Private equity investors are the ones who are achieving dividend stream-out on some of these deals very early via PIK notes. It is a means by which IRR can be increased and you can get out much quicker. And they are not necessarily bound by what you would have seen three, four or five years ago.

Liquidity is not just in the debt markets, it starts with the equity. You have to know your sponsor and what they want, because we spend a lot of time trying to leverage equity, properly leverage it right into the equity side, not through the PIK notes but more, and it is surprising how many sponsors do not want it.

You say to them, well, your IRR is this, if we do this for you at 10 points less than IRR cost, surely you are going to love that because it is going to increase whatever you have left in it by a multiple, and a lot of their views are, no, we do not want it. And the reason they do not want it is they have too much equity to spend and they cannot spend it. Once they are on a deal they want to spend it.

You have the old sponsor view, and with a lot of them it is, minimum equity, we want 20%, but they are not going to win a deal on 20%, not a deal that is being auctioned or a deal that is being contested, so where are they going to get to and how? The whole liquidity thing starts with them. There is too much of their money sloshing around, and they have it pretty cheap, and there are more funds being spun out every day. Then you come down to the murky world that we all play in. Obviously there is more and more capital there. It is not that difficult to create more leveraged structures, given that we have all kinds of investors, with different viewpoints, and it is now a global business.

But I think there are two points: there is too much equity and the sponsors are being massively aggressive. It is not stopping and aggressiveness with documentation spells trouble later. The rating agencies do not seem to be overly aggressive in their ratings nowadays, so we do have a high-yield market that is back and working very hard and is better than it was prior to the correction in May. We have a mezzanine market which is open to all kinds of investors that have never looked at it before, because we can get ratings that work, and it just goes on and so on and so forth. The interesting question, coming over to Stephen, is what stops it?

Stephen Pitts (Deutsche Bank): I disagree with that. I think everyone here is coming out like they are worried, or there is something scary going on. But it is not just the change in pricing that it has resulted in; it is the structure of the various providers of capital that is a little disturbing, as in 2002. We spent an awful lot of time restructuring different deals to learn just how important various parts of those were, and we have seen a lot of those separate protections fall away.

I do agree that that is not exactly a positive development but I think you have this enormous wall of money coming into Europe, because Europe fundamentally is an unrestructured economy so the opportunities are huge. There is no doubt that you are going to have a large amount of capital come in and try to transform basic European continental restructuring in different ways, and that is a great development. We will see a span of business in Europe like they saw in the mid 1980s in the US.

Overall it is very positive, and following that lead capital where it goes in to try to effect change of control through operations, you are going to have tons of other capital in its wake because the returns are going to be higher as well.

This is just the beginning. The US is a trillion dollar high-yield market. Europe is about US$100bn for a same-size economy roughly, which will grow to at least half of that, so you will have a five-fold increase just in that form of capital.

Christopher Baines, (Societe Generale): I agree about the fundamental reasons why there is so much liquidity. It does both come from supply and demand. That is why the market is so buoyant. Over the last few months there has been a resurgence of the trade buyer versus sponsors. We were talking earlier about sponsors bidding to get assets because they have money to put to work, in the same way as the various investors have money to put to work. Whether it is banks, funds or hedge funds, it is all coming together, and I think the question is whether or not the resurgence of the trade buyer and possibly some hybrid entities like Macquarie will lead some of the private equity sponsors to bid even more aggressively.

And linked to that is, will the banks continue to play? I am talking about the lead banks that underwrite these transactions. I think that investor protection is arguably the biggest factor for deciding whether or not people support deals at the moment. I think headline leverage is exactly that - it is a headline. But increasingly any pushback from investors on deals is obviously the broader story of the underlying credit, but it is also concerns over investor protection.

One of the reasons the market has been able to develop so fast is that traditional investors - the banks that play in the senior debt capital structure - have taken comfort in the protection from subordinated lenders. So they have said it is okay when leverage passes four or four and a half times because there is some other investor over there who is doing something ridiculous at six or seven or even eight times. One reason why the market is probably quite finely poised is that there is that pushback. It will be interesting to see whether the providers of the extra layer subordinated debt will stop playing and what impact that would have on the lead bank's ability to underwrite aggressive deals.

Hamilton: I just wonder if there an inevitability about us becoming a purely institutional driven market. If the banks will not play, apart from leading deals but not coming into your syndicate, it will be all institutional, and it just kind of feels that there is an inevitability about it all.

Ian Gilday (Goldman Sachs): Well, it's roughly 60% of the market in Europe and sponsors love it because it is cheap and flexible. There are 17 loan funds ramping up in Europe - I was told yesterday. There is so much hedge fund money, there is the wall of capital that Stephen is referring to, and we can structure it to institutions. But the more institutional we structure, the more expensive it is to sponsor, and that is hard for them to justify at a time when leveraged multiples are so aggressive. So their returns are finer unless they have the cheap funds, such as Macquarie.

The market is going more institutional and in five years is going to be more so. Does it get to the level of the States? If it does, then the signs are there: trading of loans is growing exponentially, which helps institutions, many more banks are making markets in the loan deals that they lead and others as well, but you cannot forget that the senior debt is the glue that holds these things together, and it is mostly done by the banks.

I do not find many funds able or willing to do revolvers, acquisition lines, capex lines, notwithstanding A-loans. So it will happen, but I am not sure it will get to the stage it is in the US because in Europe you have so many more countries and legal jurisdictions with parochial banks that find playing in leverage finance attractive. Basle II may change that, in that it might affect the returns that they get, given the capital they have to put against the leveraged loan. It might change mindsets, it might shrink that bank market, but we will see.

Richard Burton (HVB): We keep saying the market has more leverage because there is more liquidity. It is true if you look at the leveraged multiples - they are higher. But if you look at the nature of the risk, I do not think we are higher than before, and it is because of the nature of the money that is coming in from the institutional market. If you look back in 1999 and 2002, about 6% of the market was institutional money from CDOs. That is up to 30% or 35%. That is back-ended term money with no amortisation. So what you are seeing is your cash cover is no worse than it has been before, because you have less amortisation and we are in a lower interest rate environment. The pressure on the company is less. Just to look at the leveraged multiples is, to a degree, misleading.

Craig Abouchar (Insight Investments): But in some ways I would argue that that sets up more problems because if there is no amortisation in the early years, when things do start going wrong, which we know that they will, you are not going to have any of the repayments that you traditionally had, as all these deals are back-end loaded.

Burton: This then comes back to the documentation, and this is where looser documentation will catch you because if you have amortisation, and someone has a problem making that, then you are around the table very early. If you look at the US markets, you hardly have any A-loan in the transaction.

Gargour: You guys all assume that default rates will stay where they are. But everyone is assuming that the default rate will gradually rise. I think this economic cycle is a lot more contracted by the availability of capital. Capital is available, it is cheap. Everyone is lending us some money so that we can re-leverage and buy companies that somebody else bought in a re-leveraging, so it is all the same money, right? It is just being freely available. If the default rate cycle is quicker to ramp up, and if we start to get some turn of cycle volatility, then all the deals that do not actually pay you money upfront or back-loaded will significantly alter your economics, and they are all going to start looking bad at the same time. So leveraging is going to work against it, but there is a lot of money that is very freely available right now.

Burton: But are they not less likely to go into default if it is all back-ended?

Gilday: That is right. Here is a question for the fund guys. If you are a bank or a bank-type investor, you lend your money, you want it back, it is that simple. If you are a fund, do you really want it back or do you want the yield? And if you just want the yield, you do not care if you cannot repay on time, which means that we are creating businesses now like the US market. If they get tighter, if they get into trouble, it is just a refinance trade, and the exit is a refinance. We are seeing that now. Maybe that has come to Europe, which leads to a more institutional market, and by the way, the banks have accepted it already. So that wall of money that is coming largely has a different mindset. It does not want a quick repayment. It might not want de-leveraging by cash; though I take the point that EBIT de-leveraging is just as good, it is about yield. If you get the yield, these guys are happy for the money to be there as long as it takes.

Hamilton: But what does that mean you get? What do all the lead banks do? We do not structure perfect deals, we structure deals to sell. And I do not care if my structure does not look right if I have people out there who have said I will buy that, because it gets the deal done for the sponsor and, like it or not, the HVBs, the Deutsches, the Goldmans, we do not want to sit with Mr. Smith with four billion in a book. He has to get it off his book, and to get it off his book he has to tailor it for the guy who is going to buy it, and if that guy says, I do not want A-note, I want B, C, mezz, whatever, and I want it this year, that year, or whenever it was, that is exactly what I, or Stephen, or Ian are going to do.

IFR: Does that mean that the credit fundamentals are now playing a much smaller role in the way you structure deals?

Abouchar: I think you are right. As an investor it is my job to hope they pick through the deals and figure out which will work. But it is your job to figure out what the market will bear. And if that market will bear poorly structured deals, mispriced deals, you know that is our fault for buying them. Nobody is putting a gun to our heads.

Pitts: But if you really do want to apply discipline, there is still a badge for the bank that closed the deal.

Abouchar: There are reputation issues.

Pitts: You can go and look at default rates and see clearly what banks have done deals that have high default rates, what banks have medium, and what banks have low defaults, and the other thing we look up is how many banks break the deal when they price it and it trades down four to five points. There was a deal just recently done like that, where a company issued some high-yield debt for the first time in a while, and it traded 96 or 95 right at the get-go. Are you going to discipline those banks? Are you going to say, you know what, I do not want to really hear about your next deal, because the last deal you sold me went to 96 when the trading opened, and those two banks you know what they think? They think it does not matter.

Gargour: We told them that. We told them that on a particular German furniture manufacturer, there was EBIT of negative and its level was six and a half times and I said, yes, you are right - somebody else was picking up and doing the deal. I was away three or four days, I had not read the press, somebody else was going to do the deal. It was a poor deal when they were going to do it, it is still a poor deal, but somebody is going to do it. But the point is demand and supply is not in balance.

Baines: What matters is getting the sale done, but what is also true is that we expect the banks around this table that lead the deals to have final takes. And those final takes (a) have to be approved by credit, and (b) are a stamp of approval for the market. Different banks at different times in the cycle bid very aggressively for different reasons in terms of positioning themselves in the market. Sometimes they go mad and they start structuring deals which they have trouble approving internally which, in my experience, is always a good benchmark for whether or not it will struggle. I think we should not underestimate how important it is for the lead bank to sign off on the deal. I think that investors should pay attention to that. There are a couple of banks out there at the moment that are bidding very aggressively and those deals are failing.

Burton: I think that is absolutely right. If you look at the likes of RBS, yourselves, ourselves, it is important that investors at the banks that are arranging the deals are known to be people who are big lenders into those deals and who tend to keep it. We do not structure a deal to sell the whole deal. We want to keep that transaction on our books, perhaps be one of the larger lenders, and sometimes that means we will not be bidding the most aggressively on some of the auctions. We will drop out.

Baines: We have recently decided not to underwrite a recapitalisation for which we were the incumbent because we felt there was insufficient investor protection. This deal struggled in the market, as I understand some of the investors in the market said, well, hold on a minute, where is the incumbent? I think that has value.

Abouchar: From an investor perspective, I think it does. But I would be very careful not to put too much stock in that because, okay, you walk away from that deal today, but if the market continues doing what it is doing, six months from now would you walk away from that same deal? 12 months from now? How can you really be sure that a bank has exposure to their deals now? You have CDS, and potentially other ways of materially reducing a bank's exposure that is invisible to the broader market.

Hamilton: Do you care? As a buyer of paper, do you actually care that Chris actually is holding a big position?

Abouchar: If I hear that a bank has walked away from a deal, I definitely care, particularly if it is a bank that I respect, yes I do. Will that ultimately be a deciding factor? No. But it is a piece of information that I will keep in the back of my mind.

Hamilton: So if it was marginal, it might swing it?

Abouchar: Absolutely.

Gargour: The other week here somebody tried to market Wind mezz. I think they had upped the spread on the Bs or the Cs and increased the spread by 50bp, and somebody was trying to sell some mezz for 10bp above Bs, and it was like, yes, we do care when there is a lot of mezz on the book. We would like to have 100bp, or 150bp above. It is important for us to know who owns what. I do not care eventually that you guys are still long, but I do care to know that there is an overhang from a technical standpoint.

Pitts: Right, but only for the technical.

Gargour: And I am being sold something. When the spread has been increased on something else, they should be priced differently. So technical is very important because that is how you lose out. You did the fundamental work, but you got hit on the technical.

Abouchar: One of the things we are talking about, if we buy into the thesis that the loan market will get more institutionalised, is that you have to accept that it will become more market-to-market. This is going to bring a lot of additional volatility. And then you start running into technical issues: if these trends do not look that great anymore, I am going to start pulling money out. It is no longer about whether it will be fine in three or four years, or whatever. All of a sudden the important question becomes, is there somebody selling right now, and then it's down three, five points, and then this fallout affects the next guy.

Gilday: Well, it is the same as the US market and therefore what you need is leads and deal managers who are prepared to back their own deals and support them on an ongoing basis and make those markets. But within those institutions, does that sales and trading operate as part of leveraged finance, or does it operate separately? That is opening a whole new can of worms, but that is where this is going.

Abouchar: I agree. But from an institutional investor perspective, things are no longer as simple as saying, do I just do a refinancing and I am covered. I also care now about the volatility and factoring other things again, like lead support and things like that, so the whole thing is rapidly changing.

Gilday: If you get the deal done, and there is a loan and it trades at 97 within a week, which is just ridiculous, because what you are doing, as a lead, is cutting your own throat at some stage in the future. It is critical to make a deal work, to make it trade and ideally not through fees, if you can do that, and you do not want it to trade below par.

`Now, it is not an ideal world and these things will happen, but the investors that you have relationships with, if a deal trades down on the break and someone gets burnt, they are going to pick up that phone and have a conversation with you.

The fact is that, as a lead, you do have responsibility to do something, and it is not afterwards, it is in the structuring. It is being visible and honest as to how the book looks, and, if necessary, going back to the sponsor and trying to get the thing recut.

We had a very painful experience on Pirelli a month ago, and we had to go and do something about that book to make sure that the institutional loan would not trade through fees and, it was changed, the sponsor had some flex language in there, it allowed us to alter the structure slightly.

Hamilton: It was yourself, right?

Gilday: It was, but it is not -

Abouchar: That makes an easy discussion.

Gilday: Actually, it does not work like that, because we are completely paranoid about reputation. They will give us a harder time, and by the way, there were two other banks in there anyway, as you know.

IFR: Is there still a stigma attached to structural flex from the market's point of view?

Gilday: I do not think from the market, but I think from the sponsors. I think it is explosive.

Baines: I think there is. The market is still credit driven. There is less tolerance in Europe for going back and having another go than there is in the US. If a deal struggles in syndication, it is a failure. In many cases, the flex will limit what you can do with the sponsor, but even if you have fairly wide-ranging flex language, when coming back with version two of the deal people will always look at it as a tainted deal and it will take a lot to get it done in Europe. It is changing a bit, but there is still that approach. Changing the price does not make that much difference.

Pitts: Yes, the initial colour is always hard to deal with.

Gargour: The link between syndication, origination and distribution needs to be robust. Here is an example. You do a loan. You are going to probably come back to the market and do a high-yield deal and then you might even come and do a PIK note if the sponsor wants to get out faster. So you want a series of successes, even if they are done at a price that might be difficult for the sponsor, so that one success leads to another and gives you the ability to distribute different parts of the capital structure, and to maximise the client business you do with that sponsor. It is very important to get feedback from the investor base.

Abouchar: Yes, and even from a high-yield perspective. You hear rumours on bank syndications, that a deal is struggling or nobody wants to do it.

Hamilton: We all say that, do we not?

Pitts: Ask the investors what price they would like. It has to come cheap.

Abouchar: By the time you get the prospectus on your desk, you have already begun to form your initial protective – because you have heard other stuff. Then you will go through it and decide whether those things are right or not, but it does kind of taint you one way or the other.

Hamilton: It pains me to say this but investment banks are actually better than – my two colleagues might disagree – the more commercialised banks. We are not as good at that sounding out of the investor base and what it wants. Or we do it more slowly. One of the positives they have is that they seem to be more in tune quicker with the investor and what he wants, and probably sense before us when there is a bit of a change coming.

Gargour: We spoke about this before. The sort of savvy investment banks go for it, get the deal done and get the next deal in the pipeline, because you do not want to sit on them.

Baines: We do have extensive discussions with key investors ahead of mandate, ahead of finalisation of the terms, particularly the higher up the capital structure we go, where we seek to get anchor investors in early on and say: this is what we are thinking of, does this work for you, and we can structure it and we can price it, and by the time we agree to underwrite it, barring some disaster, in broad terms we know what the market's expected tolerance for the deal is. Obviously we cannot do it always, but we do try quite hard to do that.

Burton: I think the investment banks are exceptionally disciplined at moving a loan into the market. When you are assessing a deal, as a commercial bank arranging a transaction, you are probably going to be one of the largest investors, so we have to be more comfortable. We are not just underwriting to distribute, we are underwriting for ourselves and that alters the outlook.

Abouchar: But that goes back to how much comfort should an investor take if you are holding a large piece of your own deal? If an investment bank is doing a deal, you can assume that it is going to be sold. They have to structure that deal for the marginal investor, and that may be very different from what makes you happy as a bank holding that position. So in some ways, if the bank is happy, maybe the investor should take comfort. In other ways, with an investment bank, if the marginal buyer is happy with it, that is ultimately perhaps the more pertinent fact.

Burton: I think you have to get your credit right, because we are arrangers of deals as well, so we have to deliver what the market

will take. If it means more back-ended rather than A, then we will just have to accept that, but I think fundamentally you take a lot of comfort in the deal itself as a commercial bank.

Gilday: Maybe I can ask a question on the subject of recaps because recaps traditionally were a no-no for banks. Let us just go back to when the market did not have very many institutions and banks did not like recaps.

Nowadays, the bank's mentality has changed – scarcity of deals, wanting to earn fees and all of that – and recaps do get done. I would rather invest in a recap . . . you know what you have had for the last six months, maybe only one month, ideally a year or more, but you have the inside track in that business. You have the management accounts; you have seen management operate with leverage, et cetera,

Is there now a feeling that a recap necessarily has to have a discount, let us just pick a number and say leverage, just because it is a recap? Because there still seems to be an element of stigma attached and concern over the amount of equity going out, but these deals do get done.

Burton: I think you can make the argument that a recap is a deal you know better and should be more comfortable with. So I do not think there should be a discount.

Gilday: So a home for even more liquidity.

Burton: Yes.

Gilday: Do you, from a fund perspective, view them any differently to a new issue?

Gargour: We determine that the appetite for stressed deals, a slightly different subject, is increasing significantly.

Pitts: Huge.

Gargour: People looking at 92, 93, 94 cent senior deals are thinking, yes, I did not like it at par, but I like it at 92. So depending on the leverage and the yield to the investor, you are looking at economics that are slightly different.

Pitts: It is a good thing coming back to a comment earlier about a deal having a certain taint to it, and then it kind of gets clobbered. You all are aware of Invensys. It was really the advent of a lot of the institutional investors that allowed Invensys to be done successfully, because it did have problems. The traditional banking system was not coming to us with open arms, but you had less of a so-called black-and-white decision mentality. You now have more like: okay I like it, but I like it at this price, as opposed to I like it or do not like it, and that is a very important development as a result of the advent of the institutional investor.

And it helps a lot because it provides liquidity for different types of issues that would not have had liquidity before. Even going further down the spectrum, in the distressed sphere, it used to be if you had something that got into trouble, you would have to really worry about what you were going to do. Now you have so many different investors that love going in at different levels during the downing and distress to pick that up that you have a lot of liquidity there. I think that is a very positive development.

Gargour: The initial catalyst of price change goes to 30 or 40, whatever the price is, then finds stability, this is were the distress guys go, and then there are three probable outcomes, you know, depending on the EV (enterprise valuation) evaluation and whatever multiple you use to get the outgoings for evaluation.

What is the breakup value? What are my assumptions? You do not get the panicked overselling any more, well at least not with very liquid senior debt.

You do get it with the subordinate function, the capital structure. Fewer investors have done all the work, and really do not have enough information. So you get the overshoot, hence we started a leveraged loan fund which invests long loans, short for the same company as part of the capital structure of the subordinate, so short, you know, senior debts, subordinate, whatever, and in a neutral market, because of what you are talking about, because everyone has done the homework and it does not have that draw claw. Alstom, ABB, Alcatel, all of them, when the things went bad, they all went way below what they want to know. We all remember, right? Who would have thought Alstom does not need any bank lending, or any government support for its borrowing? So, yes.

Abouchar: I think it just goes back to the original issue of liquidity. I would also argue that, even for high-yield bonds, for the most part stressed situations are probably 10 points too high, because there are so many people looking for those same opportunities.

Pitts: You have to be right to get a decent return, otherwise you will lose.

Abouchar: Going back to your point about recaps, it is somewhat the same with secondary buyouts. You can take it on a case-by-case basis but if we had them on a first deal then, fine, we will look at it, but there are a number of deals out there that are recaps or secondaries that are struggling within six to 12 months of being re-cut. So I take your point, but at the same time, if things are going up in 12 months time, what is to keep them going down as fast if the cycle should turn? Are these businesses really that much better than before? And I am more exposed on an EV basis on these things than I was before, just because the quantum of debt is larger. So again I think I would take it case by case.

Hamilton: But there are quite clear subtle differences between secondaries and recaps, not least because with a recap suddenly there is no skin in the game, and none of us ever lend money thinking these guys are going to put more money in. But, if it is a recap and it is going wrong, they are definitely not putting money back in, they might just try and help, but we have all been there, and the thing is you keep a track record of those guys that have got money out and within six months the business starts to go downhill and you think - they knew something I did not and they were not telling me. It is what you always suspect and they will always deny it. But what you are thinking is, maybe they could see this coming and I could not, how did I get that wrong?

Baines: You are right. It all boils down to trading: it is the only way you can really get your mind around the fact that you no longer have the equity cushion. As an investor you think of jam tomorrow, but in this case if there is none, then you are in trouble, and that is when they break down. But it is incredible how certain sponsors are so skilful at extracting - they are actually out at 104.

Gargour: They get out fast.

Baines: So they have taken out more than they have put in and they still own the business.

IFR: But they have been doing that for at least a year.

Baines: Well, yes. But in the broader scheme of things it is right that it used to be an absolute no-no with secondaries, because there is no juice left, allegedly, and recaps because, where is the equity cushion? That is very much an old-fashioned approach. But another reason why recaps have worked is that some mezzanine investors are taking the view that while there is less equity cushioning the value of the company has increased. They are taking an equity approach rather than a debt approach, which is an interesting development. They are saying: okay, there is no equity, but the underlying asset is worth more, therefore it makes sense.

IFR: Are you talking about a mezzanine where deals are structured for those who have had either a debt or equity view?

Baines: Yes.

IFR: Perhaps we could move along to the subject of subordinated debt. Everybody has been interested in investing in all sorts of varieties of notes and at various times they have been popular and unpopular. More recently, one of the most interesting things has been hedge funds investing in bridge loans. And in terms of subordinated debt, who is investing in it and what is the future for structures like PIK. Which structures do you prefer, which will develop and what do you see happening before the end of this year? Stephen, if I may ask you.

Pitts: Sure. I think the future is bright. All you are changing the different types of capital structure that you are selling to different type of investors. So you are taking a capital structure, let us say a relatively simple bank debt and maybe a bond, and then there could even be equity, and you are dividing it up between folks like yourselves, other people who have these certain return parameters, and you are taking different instruments out of the capital structure to hit those return standards.

What you are seeing is the legal diversification of risk.

Investment banks often have to do very large bridge loans, and do not need or want to take the risk, particularly when there are willing and able investors, who have said they will take that risk.

A bank diversifies risk and gets its return for that bridge: you are getting paid for the return, plus your tip for organising the structure. This allows all these different new pockets of money to get into financing these types of transactions in the most efficient manner. That is why they are all grown up.

Second lien notes is a perfect example; PIK notes is a little different; the mezzanine market was big in the UK for a while, then the high-yield bond market went down and it went quiet for a while - at least with the big deals, where high-yield bonds were probably cheaper. Now we are seeing a lot of mezzanine funds and we are trying to look at different ways of doing transactions with them a little more aggressively.

Hamilton: I do not want to hold an 18-month bridge type bond.

Pitts: In a very large takeover, where you have a very large bridge, yes, the bank would like to.

Hamilton: I agree with you. I am not disagreeing with your thought process, but I am not sure that sometimes the guys buying understand the risk, because they are relying on someone else's efforts to take them out because they do not have any control; they are not doing the bond or anything like that.

Pitts: It is not like you to sell down your bridge at, let us say, 20 or 10 per cent. Usually it will hold over half your bridge, even if you sold online. You would still hold a lot of that bridge, or at least the lead banks would, so you are selling some part of it, and people get comfort from that. There are people who do it more consistently than others, so they get a relationship with people that they know and trust in that structure and they can understand them.

But it will take a bridge to go bad for people to understand fully the ramifications: the distress to the client versus the bank versus the investors in the bridge, all those types of things. The last really bad bridge I think was the one that took CSFB down back in 1988.

Banks are a lot bigger now, particularly as traditional investment banks and commercial banks have become investor based. They can handle a lot more risk, but still you do not need to make the extra return on the entire bridge versus the risk to that bridge, because you have three other transactions you want to do.

Hamilton: Ultimately, at a price, you will manage out it in some form or another.

Gilday: A lot of these funds that buy bridges are familiar with the underlying credit, especially large ones because they are in the equity.

That is what happened with Rexel, to pick a name, and there were some funds that took very, very significant positions in that hedge fund in that bridge, but they did it because they knew the underlying credit. Some funds will buy a bridge on virtually no information, only public: the last thing they get to hear is the full capital structure, because that is private until the minute it gets announced.

But they are comfortable with the credit, the management, they know how to think, they have a view and would rather put in money and take a yield than sit on cash.

Gargour: The more loans represent a bigger proportion of the total capital structure of the company, the less comfortable I am in the loan.

Gilday: You are given less cushion.

Gargour: As the enterprise value shifts, your expectations of what the real enterprise value (EV) back to the equity cushion, shifts left and right, you know, you may be left high and dry.

Pitts: Because of the curve.

Gargour: You are on the knife edge when you invest in subordinate debt. You are actually saying that this is the fulcrum . . . so you are making an assessment as to

how low you want to go, if you want to go just long, or if you are going to go short, then you have a lot of opportunities to go short on this side.

So the market is turning into something where you want to use subordinate debt, or any sort of – or even equity.

Pitts: Let us say you want to be a senior investor, but you have no clue what is senior, because you can take trades in the subordinated parts.

Gargour: And then look at the recovery values for the subordinated parts – so you can figure out what the right ratio is and look at the capital structure to figure out how much loan there is relative to high-yield bond and relative to PIK, and figure out what the right ratio to the EV and we come up with a formalistic approach.

IFR: Louis and Craig, are you happy to invest in bridge loans, bearing in mind the risk can be very large when you are waiting for a deal to happen.

Abouchar: We will look at bridges on a case-by-case basis. I think our biggest problem is...

Hamilton: Low impressions!

Pitts: You have to spike the drink!

Abouchar: Our biggest problem is mandate issues: can we do private; can we do loans versus public bonds? But again, taking down a nice chunk of Wind bridge - because we think that is a well-structured deal and it is well-priced, and ultimately we see the logic – we think the takeout is there. But there are other bridges that we do not feel comfortable with. The last thing we would want is to be in a hung bridge. So we would be a little bit more cautious from a credit perspective.

I agree with Euan's earlier comments about loosening the structures. The problem with being in a sub-debt position – with higher leverage and looser structures – is that when the market turns, it is going to be pretty ugly down there.

From a relative value perspective, no matter how loose things get on the senior side you are worse as a sub-debt holder, so in many instances, I'd rather be senior.

Pitts: I think the senior has become looser than the subordinated bond side, so actually it may increase your equity option value if that curves just all of a sudden. If the company does not have a transformation, you have more time for something to work out because the senior guys cannot just grab hold of the company.

Abouchar: But do I want to be in that position at par or do I want to be in that position at 75 cents?

Pitts: For subordinated bonds it is not so negative, because the subordinated bond covenant package was always very loose and has not changed that much.

Abouchar: Well, that is true, and - well I think that whole default cycle, we push that off for probably six to 12 months because with no debt to repay, it's relatively easier for a bank to waive a covenant breach than it is to waive a repayment. So we will be delaying the inevitable default cycle.

Gargour: Yes, monthly accounts help as well. You know, you get monthly information on more companies sent, and you do not have to wait for it – in the UK's case – for six-monthly subordinate debt reports: oh, by the way, we completely missed our targets and we are down 60 per cent, revenue is - or when your bonds go from 90 to 60; and then there is also the group of 12 or the group of 10 big bond investors trying to force covenants to be a bit tighter in Europe.

Abouchar: What, on investment grade?

Gargour: Yes, in the sort of senior unsecured investment machine. On the sub-investment grade, there has been a lot of pushing.

Abouchar: About two or three years ago, yes.

Gargour: And up to about a year ago, and it just dissipated.

Abouchar: If you look at most high-yield deals, versus early structures, they are materially better, whether they are going to get you a lot more or not remains open for debate.

Gargour: But Brake Brothers did not get done, and was only done later because the package was changed.

Abouchar: But you still get deals like Rexel, which is deeply subordinated.

Gargour: You have to decide if you have paid enough for it. This is the argument, because we think it is going to eventually go bankrupt, if it is too leveraged, or you paid enough in the shorter term that, hold on to this paper, take a few coupons, and then let somebody else take the end risk.

Gilday: So then we come round to the question of sponsors trying to restrict who we distribute to. The latest attempt is even more worrying because it is not just restricting types of investor by name and consents, but now we are hearing of documentation asks, and some banks have given it, where you restrict some parts, and you in name restrict investors of a certain type, ie. you are defining hedge funds in all but name and you are not allowed to distribute under any circumstances to those.

Burton: I think that is extremely negative but it affects what the sponsors might get in the way of the capital structure and the aggressiveness of it.

Hamilton: The thing is I am not sure that is right. The fact is that they want their cake and they want to eat it.

Baines: I think what it does is transfer the risk to the underwriting bank. We have one or both hands tied behind our back as underwriters when we cannot access the liquidity which is there, and hedge funds are very useful liquidity as a whole, but particularly for difficult transactions; the ones where the sponsor wants to push it to the limit.

Burton: But you would not underwrite something unless you have access to where you think you are going to sell it.

Gilday: Some people will.

Burton: Well, that is their mistake, because if you have been told you need to have this sexy, tailored piece that you know the demand is a hedge fund, and then you are excluding it from the documentation, you are not going to offer that piece.

Otherwise it is the mistake of the underwriting bank. How do you give your opinion that you are going to sell this to your firm if you are saying, I cannot distribute it to the part of the market that you have structured to sell it to. There is no logic there. If someone wants something, they can say, yes, I want to exclude X, but there is going to be a cost to that and you are going to end up with a package that is designed to go to, perhaps, just banks.

Gilday: I agree with you, but it is not just the given deal, because the point about these deals, especially from an investor's point of view I think, is that it is not just day one. It is what happened, not necessarily just with the company but with that deal in the market, because people like to go in for a while and come out, and there always has to be the optionality (a) if you are left with paper anyway; but (b) for that deal in the market, and it is probably a good thing to be able to go among different types of hands, because if it does not it is a poor thing and it is going to create a precedent which means that at some point there is then going to be a bifurcated market, because US sponsors simply do not want to do this. They are quite happy to just go where they are supposed to be going.

Pitts: Let us go to the core of why does the sponsor not want to talk to - to distribute to hedge funds? That is because if they feel attuned with banks, they can go and beat them up if they need some fees, right? They know who to call; they have relationships, so they feel that they are more able to negotiate any future changes in a bank deal. They feel the hedge fund is a third party.

Gilday: True.

Abouchar: Well, they are probably being more economically rational.

Pitts: Right, more economically rational.

We actually think that this is a pretty short-term phenomenon.

Abouchar: Well, it is swimming upstream versus the broader market trend towards greater liquidity and an increasing number of participants.

Pitts: As more and more private equity firms go out there and those that want the cheapest price will pay the highest value for the asset and will start winning more and more options, and so the volume of capital flowing that way will dwarf the volume that is trying to be channelled this other way.

Gargour: It is back to this equity 20 per cent that does not work anymore.

Pitts: It is a backlash where people they want to go back to the old banking system; we all get around a room, have a little cup of tea, and talk about how your covenant changes, instead of getting in a room with a bunch of other people who have slightly different manners.

Gargour: You British just sit around and have tea and leave the office at 4.30; the Europeans do things differently and they are not hungry enough!

Pitts: The US was very much that way in the 1960s, where certain commercial banks dominated the financing scene, the corporate loan, sponsor loans. Now I think the US is 80 per cent on debt and 20 per cent banks debt; it is about the reverse in Europe, so this is something I think that the sponsors are going to have a hard time. They are going to have to pay for it. And because there are not four or five sponsors competing for an asset now, it is ten to fifteen, and you have people like Macquarie coming into the frame with different return parameters, and you have the corporate world at work, where they can have synergies to parents.

IFR: Can you make it work? In a world where most people seem to be able to sell most things and there is a secondary market in loans, can you stop anyone from selling on to another, third party?

Gilday: If you exclude by definition a certain kind of fund investor, or a general fund investor, you can be reasonably specific and at the same time exclude subparticipants. I mean, if I looked at a document like that, I would just throw it straight back and say, no. It is that simple.

Pitts: I think smaller deals might work.

Gilday: But I think there is the precedent: and you accept it once, and what was acceptable for a €500m euro deal is suddenly the norm for a €3bn deal, and you say hang on a second.

Pitts: That does not work at all and that is a big problem. That is definitely a problem we have, where people try to use a €20m buy-out for a €2bn buy-out.

Baines: But that is the nature of the market we are operating in. It is a very competitive market, as we all know. There are lots of fees to be made for the lead banks who arrange these deals, that is why they are receptive to pressure from the sponsors to limit the audience and universe of banks that they go to. They should not do it, because they are making their underwriting and the placement more difficult.

Pitts: But I think there is an interesting example, where a lot of, what we are going to call banks, walked from about a US$3bn deal recently in the Liberian Republic, where the terms were not where people thought they really needed to be. And you had enough of the Spanish banks, plus a number of banks here - another group of banks - amending the deal. But you did not see one leading leveraged finance house in that deal. So there is some walking to be done.

Gargour: You see I thought you guys wanted us. Our premise in the loan fund is that the equity sponsors want to get us involved at the loan stage because their subordinate parts of the capital structure need to be done later anyway. If we are in a deal early, we are familiar with it, and we will then take their route to their equity exit out of the deal. This is the leveraging up, and the bond, and the PIK, and whatever is their way of getting out of the deal.

Maybe there is a counter-trend on deals saying, we do not want people that are too short-term to be involved in these deals, because they will flip it. I am not sure of the rationale.

Gilday: It is sponsor by sponsor. Some are very strong in this and others less so, it does not matter.

Gargour: Five years ago we could not get in a loan deal, unless it was like the Blackstone hedge fund arm getting into a Blackstone deal.

Abouchar: A couple of years ago, they tried doing this with Mezz, and then -- before high-yield was taking a lot of Mezz away - when Mezz was really hot back in 2002, 2003, there are guys that just do not want hedge funds in. There was a recent deal that has a structural flex that vastly limited transfer language and nobody dropped out.

IFR: Which particular hedge fund is rational?

Abouchar: There is a massive fear of the unknown, and the unknown is: will it be bond investors, or hedge funds, vulture funds, whatever you want to call them? Traditionally it has taken a long time to get to the point where senior lenders can see the advantage of distributing to institutions.

It used to be, do we really want hedge funds sitting alongside us?

I think the market has learned to be comfortable, but there is still a lot of fear from different sponsors. Is it rational or not, I do not know, it probably depends on which side of the table you are on.

But you look at what is going on in the equity market, and the different things we have seen there with hedge funds taking positions, and how management teams across Europe at various companies have felt really shoved around by these guys. I am sure private equity guys are saying, well, we do not want that to happen to us, so let us exercise some degree of control over who we are in bed with.

I think they are trying to swim against the tide and I think when somebody is stuck with a deal, they are going to have to give on it. I think right now all things are good - maybe they can get away with it here and there - but I hope it is not a thing to last, because it does nobody any good.

Gargour: The price of equity and hedge funds resemble each other. But you guys are the providers of capital and we leverage out capital and try to make a good return. So we are in direct competition, unless we work together, and I think that is what is going on.

Pitts: This is the other prelude question about whether Mezz and banks will be disintermediated, and a flip side to the question that Ian just put forward, whether you know issuers can just go and distribute their deals themselves.

Hamilton: Is there not another subtlety, which is that if there is too much of that these guys are starting to eat our lunch. We still have some power at that point when you say, if you are going to keep doing that, then I am not bringing you anything, I will go somewhere else with it.

So I take it almost as a natural stop on it. You will always have some of that where, you know, a sponsor will line up a Louis, or a Craig, and say, will you take down 200 of this, please, and we will do it together.

Pitts: The sponsors try to get as many capital players involved as possible.

We saw one deal, where one of these hedge funds came in and liked to do bank loans, and they romped in and said this and that, and we said to the sponsor they are not long-term holders, and we do not feel comfortable with them sitting alongside of us. Long debates, special favours, this, that and whatever, so they are in the capital structure. Then the storm hits in the second quarter of this year, thee hedge fund is screaming to get out.

They really do not have that long-term relationship, that long-term franchise. They do not have that reputation they have to worry about. So those are all going to be factors, as is the ability to collect. We are kind of a collecting point.

I did not want to let them out. I was personally very much in favour of just leave them, but then the sponsor kept screaming back to us about, you know, then the other banks would get worried and we would have to start unloading it, and there would be a problem.

Gargour: How big a percentage of the deal was it?

Pitts: Between a quarter and a third. It was enough to rock the boat. And all for taking those tiny fees upfront. That was the whole purpose of getting them at the beginning. Anyway, so we have not seen that since, but we do not show that particular fund anything, because they are on that list where we say, if you really want to do that, then you go ahead and good luck, and you can even call yourself an investment bank if you get big enough later on, but for now - we feel pretty strongly.

When you do a deal and you structure it, you have to be very careful about whose hands you are putting the paper into along various parts of the process, not just for yourself, but for your reputation and for the other participants and investors -- the other hedge fund investors that you are distributing the paper to. So I am not going to buy paper if one guy has a large segment and he could turn, you know, willy nilly at any point.

Gargour: I think the investment philosophy is what you need to determine of an investor, and not necessarily the type of leverage or capital which he employs. So whether it is leveraged or unleveraged, if they are your short-term flippers if you assign to a flipper, you are forever shooting yourself in the foot; but if these guys are longer term investors, they work with you, they buy into a deal and you know that they are safe hands, then regardless of how they fund themselves, whether they are a bank, hedge fund, or investment boutique, you have made a qualitative assessment of the client's value, and not necessarily an assessment of how they raise it.

Baines: The only way to get a hedge fund in for some of the sponsors that are notoriously reluctant to get hedge funds in, is to really promote the buy and hold mentality, investment philosophy of those investors.

Pitts: There is also the issue of whether it is fair or not, or whether it should be changed. Some institutions, when they buy a loan, can make a decision that is good for the period of the loan. Other hedge funds have to market-to-market.

So in a market change that occurred in the second quarter, they did not want to market-to-market, and they are disadvantaged as being long-term holders. That is why it is still very important to have a fundamental core banking market behind everything, because that market did not really get scathed.

Gargour: Does a loan CDS market help the guys? Does it help you guys help the investors hedge? Does it help the investors see what the heck is really going on in front of us?

Pitts: You can use the crossover index if you have a bunch of bridges on and America goes sour. Although the crossover index is a misnomer, it really has a lot of triple Cs, single Bs, double Bs.

Abouchar: That is much more a legacy of when it started, when there was not enough high-yield CDS to put into it. Pure high-yield CDS is slowly growing.

IFR: Do you sense that the hedge funds would disintermediate?

Abouchar: Conceptually, it seems to be exceptionally difficult to really make a material effect in the market. With all the relationships of any given bank there is no way a hedge fund is going to be able to replicate that kind of infrastructure.

Pitts: Well, that is why I said: if you want to be an investment bank, good luck.

Gilday: Maybe the question is: how many of them disintermediate the private equity world?

Abouchar: I think that is the more interesting question.

Gargour: That is really what we are talking about...

Gilday: ... because that is happening.

Gargour: We would love to if we could.

Abouchar: But I would argue that, given the ability of private equity guys to take out money in a deal in six months, flipping companies in under 24 months – people look at this stuff and say, what are these guys doing, these guys are not operating businesses, they are financial players, pure and simple, and if they can do that, why can a hedge fund not do it?

There was a recent buyout in Europe where the sponsor, Blackstone relisted it in the US with 18 months and called it value arbitrage, trading a low multiple in Europe for a higher one in the US. Why can a hedge fund not do that? It is exactly what hedge funds do.

Pitts: But they were talking a lot about it a year ago but it seems to have died down a little bit now.

Abouchar: There was, but it seems to me that, as private equity guys get more and more short-term, it becomes less and less about running a business day-to-day. You know, and just flipping business for financial gains, not changing the business at all, but who cares. From an investor perspective, that worries me, because then I am looking at these guys saying, do you really know how to run this business?

IFR: The one part of the capital structure I know that we touched on a few times now is loans. What do you think of the trading of loans?

Gilday: I think Deutsche really started it probably six years ago now.

Hamilton: Are you going to blame the Germans?

Gilday: No, it is not blame, it is a compliment, and I know they saw it, really, I mean, they saw it before I. They built it up and did it very well and it is a leading position that that firm has right now.

There are two different ways of doing it, but it seems it is getting more and more aggressive; firms putting on one trader, two traders, plus a distressed team, plus sourcers, plus salespeople, whole teams moving to join other firms. I think it is a very helpful thing, because if we want size in the markets in terms of deals, we want liquidity from institutional investors. But you have to have instant liquidity for them, and you get that through broker dealer desks. You just have to have them, and it helps an arranging bank as well if you follow your own deal. You make a market in your own deal, on the loan, on the Mezz, on the second lien, on the PIK and on the high-yield if it is there.

IFR: If people keep seeing loans as more and more tradeable, do you foresee any dangers?

Gilday: If someone is investing

from a fund perspective in a financial instrument, he expects to be able to go in and out. If he cannot do it the market shrinks, and if the market shrinks, certainly the size of deals we are going to be looking at is going to be smaller, and I do have a fundamental credit view that bigger businesses tend to be stronger credits, just because their management are able to handle a bigger and more profiled business generally.

Therefore we want to be doing leverage deals on larger businesses, and to do that you need loans to be tradeable.

Pitts: I would say that is the real story of this year – it is really just the size of transactions that are getting done. You are seeing multi-billion dollar deals come out of every which way, and I mean there are six of them that we have focused on in the last three months that have all come through, and it is just unbelievable, I mean who would have thought that? We had some fallen angel activity a couple of years ago, which did not have a very, very large sponsor to take over its very large corporate takeover, with big, big finances.

So to do all those, there has to be a market base, where you can see where securities trade: it is transparent, it is diversifying risk, and it is allowing for more liquidity and therefore lower costs of capital free activity.

IFR: But what about when someone is buying a loan, gaining access to the documentation and updates, and then trading the bonds with the benefit of that information?

Gargour: Well, there are court cases in the US about that right now.

Abouchar: The problem is that ultimately it is a regulatory driven thing and regulators are always going to lag this thing. They will probably get something blow up and then they will step in with a rather heavy foot.

Pitts: There is a court case where several commercial banks are suing a hedge fund in the US over using inside information from I think part of the bank circle to trade the other securities.

I think 99% of people try to be very, very, very careful about that, because, you are right, the law is not as carefully defined around loans and the creation of these loans.

Abouchar: Yes. Well, I mean, is there really any standard for what goes into a strip (public/private) book or not?

From a bond investor perspective, I always will jump up and down, and scream and yell, and rant and rave, and try to get loan covenants, and the response will be, it is private, you cannot get that. Well then how can you have some public and private investors in the loan?

IFR: Thankyou everyone for attending, and thankyou for your contribution to the roundtable.

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