Sunday, 23 September 2018

Levergaed Finance: Sponsors flex their financial muscle and rethink ABCs

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Structural flexes and shifting emphasis in the allocations of A, B and C tranches have been developing for a while in the European leveraged loan sector but some recent deals suggest that the market is now moving quickly towards a whole new pricing dynamic. Donal O'Donovan reports.

The first quarter saw the acceptance of investor flexibility establish itself as a guiding principle in the leveraged loan market. A recent spate of European LBO financings have been launched without an A tranche or have undergone radical structural flexes after syndication. At the same time price flexing, a precursor trend in 2006 to the current round of structural flexing, has become increasingly aggressive and now shows signs of spilling over from the leveraged to investment grade loan market.

KION's €3.5bn financing of this year and United Biscuit's £1.45bn facility of late last year were launched without any A tranche. United Biscuits then undertook a structural flex this year in which the C tranche was dropped and the mezzanine and second-lien tranches were reduced, and the amounts rolled into a beefed up B tranche. On TdF's €3.97bn financing, the mezzanine tranche was dropped and spread among the second-lien, B and C tranches.

In February BNP Paribas came to market with a waiver request for a major restructuring of the €2.8bn financing put in place in 2006 backing the creation of Numericable - sponsor Cinven's merger of French cable companies Ypso, Altice 1 and Noos.

The Numericable deal, successfully closed despite initial investor kickback, was in effect a time delayed structural flex - creating a €800m nine-year term loan C at 275bp over Libor that will replace the €250m nine-year second lien tranche at 475bp and the €500m 10-year mezzanine tranche at 912.5bp.

European leveraged debt structures used to be formulaic but over the past 18 months those structures have been fine-tuned to suit particular circumstances. However, the number and regularity of increasingly unusual structures indicates a double shift for the European market.

At a basic level, the trimming or eradication of the A tranche highlights the hugely expanded impact of non-bank lenders that invest in all other parts of the capital structure, and the unpopularity with many sponsors of amortising tranches that eat into cash flows.

The amenability of bookrunners and investors to the re-ordering of capital structures after launch suggests that the changing investor base is pushing the market towards a public markets model in which structure and pricing are set in the market and books built rather than run.

The convergence of the private loan market and the public high yield market model is also seen in the advent of ‘covenant light’ leveraged loans contracts in Europe in early 2007, after the practice had been introduced and accepted by investors in the on high yield issues – in particular non bank investors inclined to buy right across the capital structure.

The two initial covenant light deals World Directories and Trader Media, feature contacts with maintenance covenants stripping out, leaving only incurrence covenants. Traditional maintenance covenants allowed investors to regularly test a credits interest cover, leverage, cash flow and capex on a quarterly basis whereas incurrence only covenants mean investors are only able to test a credit when a specific event like a refinancing or an acquisition triggers it.

Trimming the amortizing A tranche cuts the draw on sponsors’ cash flow, reducing expensive subordinated tranches in favour of senior debt cuts the cost of capital. Removing maintenance covenants, while it does not impact the cost of capital does increase sponsors’ flexibility and control over their portfolio businesses.

Sponsors are armed with huge amounts of money at the moment and competition among them is driving up buyout prices, in that context the ability to finance deals with minimum impact on borrower cash flow is of growing importance.

"Banks in turn are competing among each other fiercely to create terms and conditions that will best suit sponsors' interests," said Edward Eyerman, managing director and head of the European leveraged finance team at Fitch.

Competition among banks and institutional funds in turn means sponsors are demanding ever weaker lending contentions as well as terms.

Charlotte Conlan, head of leveraged finance origination at BNP Paribas, agreed. "Sponsors have always sought the best available package but this is now increasingly driven by highly flexible investor attitudes and never-ending liquidity," she said. "As a result, the leveraged finance market is now a much more investor rather than a credit-driven market."

Conlan said structural flexes on deals helped establish new market norms. "Structural flexes are being used to find the market level. Where a structural flex has worked – removing the A, or switching subordinated debt into senior, for instance – the new structure sets the bar for how future deals will launch," she said.

Sponsors, however, are not the sole beneficiaries. "Key pressure for flexible structures comes from sponsors, but back-ended repayments can also suit institutional investors and hedge funds that don't want to be repaid in the short term," said another banker.

That KION's €3.5bn loan supporting the largest ever German LBO has just been launched without an A tranche shows that these new structures are becoming mainstream, especially as it comes after the TdF's aggressive structural flex.

Some see the absence of an A tranche, in particular, as a potential credit issue because the lack of amortisation creates back-ended repayment structures, potentially storing up trouble for later, especially if higher interest rates start to bite. Bankers acknowledged that there was risk of credit deterioration but played down the impact.

"For the creditor this does mean additional risk, though with default rates low and the economy strong that is not having an effect on investor appetite. Banks also have been happy to join the B and C tranches where the A is not available," said one banker at Morgan Stanley.

And changing debt structures do not have to lead to weaker credits.

"In credit terms, the key is to have mandatory pre-payment from excess cash flow," said Michelle De Angelis, senior director of leveraged finance at Fitch. "This tends to be strong on term loan B tranches in the US, though it is not clear that that has been taken on board to the same extent in Europe."

BNP Paribas's Conlan was more emphatic, although she conceded that there was potential risk in non-amortising facilities.

"Changes to the capital structure do not necessarily have adverse implications for credit quality," she said. "What can be a credit issue, however, is the absence or diminution of an early warning system. Without amortisation, for example, it is easier for a borrower to continue to fulfil just its interest payment obligations when a business might be struggling and consequently delay the opportunity for lenders to take action."

However, amortisation is not the only way to reduce leverage. Borrowers can use increased cash flow to reduce debt, or use cash flow to expand the business and deleverage through earnings growth.

Aggressive re-pricing

Structural flexes are not occurring in isolation, the trend is just one part of the broader shift in emphasis within the leveraged loan market from priced deals being syndicated out to investors towards a more fluid, markets approach. March in particular saw some aggressive reverse flexing on the pricing of deals in syndication.

Bookrunners RBS, UBS and UniCredit twice reverse flexed pricing on the €995m facility backing sponsor Cinven's €1.285bn buyout of Phadia from PPM Capital and Triton. The second price flex reduced the margin on a B loan by 12.5bp to 212.5bp over Euribor, the margin on a C tranche from 250bp to 2.375bp and the margin on an increased second-lien down from 375bp to 350bp over Euribor. A €220m PIK loan, which replaced the deal's €180m mezzanine tranche, had earlier been decreased to €160m.

At around the same time bookrunners BNP Paribas and CIBC World Markets returned to investors with a proposed flex on the €382.5m facility backing sponsor Investcorp's secondary buyout of Armacell International, a German manufacturer of specialist engineered foam products.

The price flex includes a 25bp reduction on all parts of the senior facility, including a drop to 200bp over Euribor on the A tranche and 225bp on the B and again a reduction in the size and margin on a mezzanine piece, this time in favour of an increased second-lien tranche.

Both deals again highlight the extent to which no element of a leveraged loan syndication can now be treated as ‘final’ at least until signing in.

New dynamic

With investors unfazed by credit deterioration fears and the market moving towards less rigid approaches, a new dynamic is clearly developing.

The real impact of heavy structural flexes is the changing way in which the market is processing syndications. Investors are increasingly not only accepting changes but even factoring the potential for flexing and reordering into their initial responses to deals.

"Investors now anticipate flex when a deal comes to market, which effectively means the debt is being sold on a bookbuild basis, even if informally," said Conlan. "This suggests we are moving in the direction where deals are priced in the same way as the bond or equities markets. There is nothing to impede that drift, and nothing to deter a bookrunner from coming to the market with a price range and letting investors set the correct price up front."

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