Intouch Spring/Summer 2008
Mid-market deals remain resilient
In spite of the credit crunch, mid-market buyout loan sourcing remains possible in contrast perhaps to larger deals. Certainly, deal structures have become more conservative, but banks will still buy sound credits.
To judge by the headlines from the finalmonths of 2007, Europe’s private equity buyoutmarket had juddered to a virtual halt.With a credit crunch in full swing, the bankswere either unwilling or unable to lend and buyoutswere starved of the debt they needed.
Certainly this was the case for European large buyouts, where the number of buyouts worth more than €1bn fell by 43% from 23 in the first half of 2007 to 13 in the second, according to Unquote. Yet in the mid-market, the picture was not so bleak. Buyouts in the €25m to €1bn range were down, but only by 6% from 274 to 257 (see graph).
While contagion from problems in US sub-prime mortgages had virtually closed the market for financing multibillion euro deals, Europe’s banks were still prepared to lend to mid-market deals. Consequently, mid-market activity remained fairly resilient. That said, even these deals were being completed on far less favourable terms.
“It is tough for the big deals,” notes Andrew Golding, Banking Partner at 3i. “The appetite of any bank to underwrite more than €500m is very small. The very big buyouts totalling, say, over €2bn in enterprise value (equity and debt) are virtually impossible to get done. In the mid market, though, deals are possible and banks are willing typically to underwrite up to €250m each and sometimes more.”
How the markets dried up Debt market liquidity started to dry up in the late summer 2007, when the US sub-prime mortgage crisis spread to structured credit markets, and particularly collateralised loan obligations (CLOs). According to Golding, CLOs had become the primary buyers of buyout debt in 2006 and 2007 – snapping up as much as 80% of all buyout debt issued in the United States and 60% in Europe. Emerging problems in US sub-prime mortgages – also held by CLOs – virtually stopped CLO issuance in the second half of 2007. Investment banks that had recently underwritten buyout deals suddenly had far fewer buyers. Barclays Capital estimates investment banks were left with approximately US$160bn of unsold deals in the United States and €70bn in Europe.
The buyers that remained were generally banks buying for their own balance sheets. In contrast to the investment banks that had underwritten debt at the price they could sell it to the CLOs, these banks would only buy at a lower price justified by the debt’s underlying creditworthiness.
“Banks had previously adopted an underwrite-to-sell philosophy,” explains Golding. “The market dropped some of the fundamental tenets of good banking. We all knew this would end in tears and it has.”
Changing deal structures
Even in the mid-market buyout financing has become more difficult. For a start deal structures have become more conservative. Take leverage, for example. Whereas the financing of a buyout might previously have been supported by 20-25% of equity, today that has crept up to 30-40%. Additionally, the amount of mezzanine finance used is growing.
At the same time cheap subordinated (2nd lien) senior debt and wholly subordinated PIK (payment-in-kind) notes are disappearing from deal structures. Both had both become common in recent years. But in a risk averse environment, subordinated debt is being repriced or shunned because of its junior repayment rights. Meanwhile, the hedge funds that were buying PIK notes have largely stopped. In mid cap buyouts at least, traditional mezzanine debt has re-emerged to take up the slack.
Those buyouts that are still being financed in the mid-market (such as the recapitalisation of Ambea – see sidebar) are so-called ‘club deals’. Instead of being underwritten and distributed by a large syndicate of banks, these are being taken by small ‘clubs’ of perhaps four or five banks that will probably hold the debt themselves.
Demand for debt is far from uniform, with pockets of demand existing in different geographies. For example, 3i has recently been able to find banks with appetite for debt in Scandinavia and Germany.
Strong relationships with banks are also extremely important at times such as these. “Rather than trying to get the last bit of leverage or cost from banks, we have been focusing on working closely with our relationship banks for some time,” says Golding. “This has proved to be both a lucky, and sensible, strategy.”
Anticipating healthier markets
As the months pass by without significant improvement in the credit markets, Golding expects that what he calls “the common sense gap” between the prices vendors expect when selling businesses to private equity firms, and those that can be justified at a time when debt is more expensive, will close.
He also anticipates that, eventually, the credit markets will regain their health. “While it will take time, there is still financial liquidity out there looking for good investments like buyout loans,” foresees Golding. “The market will adjust to creating alternative structures to tempt investors back.”