Syndicated Loans 2005 - Long Division
With institutional money continuing to swell coffers and new liquidity sources to tap, the private equity industry has set its sights higher than ever before. The competition for mandates is forcing banks to push structures and pricing to breaking point. But while pricing has tumbled for some deals, others have faced sticky and painful sell-downs, creating two markets in one. Adrian Simpson reports.
If 2004 was mezzanine's year as asset of choice in leveraged lending, this year must belong to second-lien. Previously regarded as a US financing tool, use of the asset class has rocketed since Brenntag introduced it to the European market in 2003, with over 30 deals making use of it so far this year. The growth is just one more indicator of the abundance of liquidity that continues to dominate the market. As new sources of liquidity have opened up in the shape of credit funds, CDOs and hedge funds, second lien has provided another way of tapping this extra liquidity, elbowing its way in forcefully between B/C tranches and the higher-yielding junior debt.
Sponsors have been quick to spot the opportunity. Their enlarged appetites have resulted in a blowout year for the leveraged loan market, which has seen 183 issues worth US$142,976.3m in the nine months to September, shattering last year's 12-month total of 242 deals worth US$130,163.9m, according to figures from Thomson Financial. More than 20 of these deals have generated debt mandates topping the €1bn mark, creating plenty of scope for bankers to fine-tune structures to fit demand. It is little wonder that this is the year that European LBO record was smashed with the €7.55bn debt backing Naguib Sawiris' €17.2bn acquisition of Wind Telecomunicazioni, the Italian telecommunications provider.
Perhaps the biggest impact of the additional liquidity has been on pricing. This has been particularly evident where performing credits have been refinanced. In April, the market gasped as SEAT Pagine Gialle launched a €2.62bn refinancing that slashed margins on the A and B tranche by 40bp and wiped out the C tranche altogether.
Although funds groaned at the loss of blended yield, Charlotte Conlan, deputy head of loan syndications and trading at bookrunners BNP Paribas, was unrepentant: "For the right credit, 250bp/300bp is the market's new level for B/C paper. While flexing to this level after a successful syndication is easy, the real challenge is to set pricing at these levels or finer from the outset." While investors may have complained at the time, their actions appear to support Conlan's view, as SEAT's paper now trades comfortably north of 101 in the secondary market, if supply can be found at all.
It did not take long before leads JP Morgan, Lehman Brothers, Banca Intesa and UBM were answering Conlan's pricing challenge with their €1.83bn deal backing the primary LBO of Pirelli Cables by Goldman Sachs Private Equity. The July deal launched with pricing on the B and C set at 250bp and 300bp, although the big cut was on the chunky A tranche, which launched at a 150bp-225bp and settled towards the top of that range as syndication progressed. And as the third quarter drew to a close, BNP Paribas, Calyon, HSBC-CCF, Natexis Banques Populaires and RBS really pushed the market's limits with the €1.588bn recapitalisation of Vivarte. Pricing at launch threw any semblance of an established pattern for European pricing out of the window, as the deal features a 175bp margin on the A, 250bp on the B and 275bp on the C tranche. A successful syndication at or near this level would make Vivarte a landmark deal for the leveraged market, as it will firmly establish the principle that a performing asset can demand lower pricing, regardless of sector.
Previously, such aggressive terms have been the territory of businesses with a high cash conversion ratio, typified by the earlier deal for directories publisher SEAT Pagine Gialle. Although Vivarte is both well-diversified and not over-leveraged, the deal is still firmly rooted in retail, a sector known for its high operational gearing and sensitivity to consumer sentiment.
Despite the breakdown of the established mantra for pricing European deals, bankers do not feel that the market has moved fully towards the flexible pricing or bookbuilds that characterise leveraged lending in the US.
"These changes do not represent a move away from the traditional credit-driven approach", insisted Conlan. "A more dynamic price environment means more work for banks in pricing the credit correctly. We are still a long way from being ratings-driven, the market is still governed by bookrunners' judgement for where pricing should be." If so, it may explain why pricing has only moved downwards, as arranging banks may be hesitant about persuading their private equity clients that a deal should price above market norms.
However, with the 'pricing range' approach, common in the US, beginning to make an appearance in Europe, notably on transactions for Ypso and Sanitec, it may not be long before deals begin wrapping up syndication with B/C margins up to the 400bp mark.
Pace of change
If the impact of additional liquidity is changing the nature of primary markets, secondary players must be dazzled by the pace of change wrought by the newcomers. "The rise in the number of institutional investors has brought about a fundamental change in the way banks' secondary operations now function," said David Fewtrell, head of secondary loan trading at HSBC. "Institutions are more dynamic than banks. They tend to not labour over credit decisions in quite the same way as banks and are content to pay above par for paper in secondary to ensure they are fully allocated."
While this may bring benefits to banks that use the secondary market as a way of extending primary distribution, traders are now expected to remain actively involved in a credit long after the initial sell-down. Fewtrell continues: "Institutions will often trade in and out of transactions, either to take advantage of market pricing or in the event of adverse news, and will look to the lead banks to support their own transactions in the aftermarket."
This does not mean that banks are expected to step in and take a loss in a falling market. The real winners among arrangers will be those who recognise the mark-to-market pressure that typifies many funds' operations and help them to manage their exposure over time. For banks that can get the balance right, the reward will be a regular source of liquidity that may help get deals done that a traditional bank audience may have shied away from.
With so much liquidity on offer, banks risk making the dangerous assumption that almost any deal can expect a warm reception in syndication. Sadly this is not true, which has led to a number of deals falling victim to an increasingly dichotomous market. The gulf that has opened up between deals is perhaps most clearly illustrated by their relative performance in the aftermarket, which has seen a leading group of credits break away from the rest, with bid-only markets settling above the 101 mark, while others have experienced the rollercoaster rides of coordinated sell-downs and low-ball bidding.
While the uncertainly triggered by the May downgrades of automotive giants General Motors and Ford may have contributed to the problems faced by deals like Wind, Debenhams, Sanitec, Grupo Coin and SigmaKalon, the fact that the now recovered market continues to divide deals harshly into winners and losers indicates that something else is at play.
"The GM/Ford downgrades certainly affected some of the US institutional appetite, but deals have struggled for their own reasons. The biggest factor governing a deal's popularity is still the underlying credit quality", said BNP Paribas' Conlan.
This is an important distinction given the limited resources that most banks have to assess leveraged deals. With the market's engorged pipeline, aggressive structures or weaker credits run the risk of being passed over in favour of easier or safer options, leaving arranging banks to reflect on the market's capriciousness while nursing painful underwriting positions.
Paradoxically, the abundance of liquidity and rampant investor appetite may be contributing to the market's developing underclass. Sponsors' thirst for cheap recapitalisations and large dividends is fuelling leverage levels and undermining lenders' confidence by reducing sponsors' risk capital. But with four or five sponsors chasing every deal, and multiple banks chasing every sponsor, the competitive pressure to win mandates and maintain sponsor relationships is making it very hard for common sense to prevail. The development has seen leverage break through eight times net debt to Ebitda, as seen on Yellow Brick Road's recent recapitalisation via Barclays and Merrill Lynch, shattering the five times that would have raised eyebrows just a few years ago. Competitive pressure has also allowed sponsors to request terms that banks would normally find abhorrent, such as on Nordic Capital's recently launched recapitalisation of Ahlsell, where leads Morgan Stanley have included a management change clause that, under certain circumstances, would allow debt to carry over to a new sponsor.
With default rates still low, arrangers are betting that deals can take the extra pressure. But as the recent woes in the automotive and plumbing products sectors demonstrate, cracks can appear very quickly in highly leveraged deals, leaving end investors with plummeting secondary positions. Such cases serve as a reminder of the responsibility banks have as front-line decision makers in allocating capital. But as more players enter the leveraged space in search of higher-yielding assets, the pressure of competition could lead to management teams becoming the last line of defence against an overheating market.