The best of times, the worst of times

01 May 2008

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Looking at the new state of the debt market

What a difference a year makes. This time last year Europe's largest ever buyout, Kohlberg Kravis Roberts' (KKR's) £11.1bn acquisition of UK chemist Alliance Boots, was in the works buoyed by an £8bn debt package. Private equity had prevailed despite the fierce wind blown by critics - unions and governmental bodies alike were teaming up to knock down the capitalists.

What hurt private equity in the end was precisely what had propped it up for so long - the debt. Indeed, the debt package for the Boots deal went on to face enormous difficulty in syndication markets and people close to the deal even revealed that the banks came back to KKR begging for a restructuring of the package. However, what is surprising is how surprised people seem to be: for years industry players have been saying the debt bubble was growing and would inevitably burst. In fact two years ago, an article published in Benelux Unquote" (April 2006, page 12-14) described an overheated market characterised by aggressive debt structure, higher risks, low rates, very liquid markets and an increasing number of institutional investors. It contained testimonials from deal doers saying it would not last. Indeed, in Benelux, Q1 08 saw a two-thirds drop in volume on the same quarter last year to just seven buyouts made and 50% drops in value to just EUR600m in the first three months of this year. So, what happened?

For a start, the leverage markets witnessed unprecedented levels of debt and decreasing levels of equity in deals. While the debt-to-equity ratios were rarely as extreme as deals seen in the late 1980s in the US (where 90% debt was standard in some mega-deals), the sheer volume of mega-deals propped up by hefty debt packages was staggering. Average debt levels stood at more than 6x EBITDA - with a number in the teens, according to sources. Include the 'equity cushion' of just 20-25% and enterprise valuations reached 10x a company's gross earnings and above.

What goes up must come down and today the trend is towards a reduction in multiples. Experts estimate they are down by at least a tick (1x EBITDA). Pierre Chabrelie at ING in London believes that for the larger deals, the senior debt stands at 4.5x EBITDA; for deals with a mezzanine strip, the total debt will rarely exceed 6x EBITDA; and for smaller deals, the debt will now stand at 5x EBITDA. As a result, equity cushions have had to increase to make up for the gap and now range between 35-40%, leaving enterprise valuations down and on average closer to 8.5x EBITDA.

Stuck in the middle

It's not just the proportions that have changed, but the layers too. In 2006 and 2007, capital structures had become very aggressive, containing a dizzying number and array of layers. Traditional A, B, C tranches gave way to hybrid products, and in particular second lien. "This last phenomenon resulted from the high level of liquidity available on the market and the hunger for leveraged paper," explains Mark Milders at ING in Amsterdam. The product squeezed out traditional mezzanine as the subordinated debt of choice, offering lower premiums yet often taking on riskier positions; a dream for sponsors, but really many now admit that second lien was nothing more than 'mispriced mezzanine'.

Today, we are back to basics. Structures will become less stratified and mezzanine is making a comeback. "There will be more mezzanine in the sense that the debt second lien has disappeared and senior debt has come down, while purchase debt prices are still on the increase, equity checks have increased some, the gap is now filled by mezzanine," Milder at ING states. Arjo Stammes of NIBC Capital Partners further explains: "There will be more mezzanine involved in LBOs in order for private equity houses to reach their targets and to improve returns. However, mezzanine pricing is increasing as well." This is good news for mezzanine - not only is demand back, but with terms that make it worth their while. Second lien is extinct and covenants are back in a big way. "Banks are asking for greater certainty: more and stricter covenants and stricter financial documents," comments Stammes.

Tough get going

Changing terms mean changing faces. Whereas in 2006 and 2007, banks used to originate LBOs and sell them down, keeping only a small stake for themselves and earning fees on both syndication and servicing, now the scene is less lucrative and more tricky.

"A large number of players are not active in the market. We passed from 150 active funds to 15 or 20. So there has been nearly a 90% drop in liquidity," notes Milders. At the same time, "many American banks just left the market altogether. Local banks are still very active because mid-market transactions have been very much less affected by the liquidity crisis compared with large jumbo deals", says Chabrelie.

This aversion is down to trickier business, although not all are shunning deals completely. For example, in January, CapVest took a majority stake in coffee roasting company Drie Mollen with Rabobank providing the debt. A month later, leveraged by ING, Friesland Bank purchased a majority share in Arboned. In March, West LB provided debt, facilitating DBAG's acquisition for EUR100m of ICTS Europe, a company specialising in security services for airport and airlines. Milders says: "Assessing market risk is fairly difficult at the moment. We should see more clubbing, however some banks will go up to 50% or 100% for underwriting if the asset is sound or well-known." In fact, for deals with an enterprise value of less than EUR100m, Chabrelie says there is no change. For deals valued between EUR100-250m, there are more club deals and above the EUR250m mark, there will be fewer transactions than in the 2005-2007 heyday. These brackets are roughly the same throughout Europe, although the Nordics continue to do deals up to the EUR500m mark relatively swiftly.

Looking ahead

Just as the market worries about how deals will be made in the near future, other prudent GPs are focusing on their existing portfolios. Buy-and-build has become increasingly interesting for buyout houses eager to deploy capital and monetise extant investments. Chabrelie observes that banks are also strengthening their portfolio business in anticipation of potential defaults. They are also focusing more on priority customers they know and trust, as well as looking more to cross-selling banking products to improve profitability of leveraged finance transactions.

Investors predict that the current sombre situation will remain for the next 12-18 months. However, in Belgium there are minimal changes as the market has been driven historically by small- to mid-market transactions. It thus follows that the larger market in the Netherlands is more affected by the credit crunch since it has seen a larger proportion of mega-deals.

The European Mezzanine Review 2008 is out now

This fifth edition of the European Mezzanine Review gives you a complete overview of the European mezzanine market (from 2003-2007) in an easy to read format. The fully validated and comprehensive information allows you to analyse this market in depth.

For more information and to order, visit www.unquotebooks.com.