Q&A - Before the thaw

Much has been written about the frozen debt markets, and, as we speak, the industry has had to deal for almost a year with a very different situation in the capital markets. What is your take on the current LBO situation in Germany?

The markets clearly remain deeply affected by the credit crisis, which manifests itself in far less debt market liquidity as a large proportion of institutional investors have been forced from the market. Some banks remain very much open for business, but there is still a focus on clearing the backlog of hung deals.

What does your summer pipeline look like and how many deals do you hope to complete?

Our pipeline is relatively full, but not as full as we would like. Compared to 12 months ago, deals are down by at least 20%. Large deals are certainly far rarer and also more difficult nowadays. In 2006 we would see banks comfortable taking on large underwriting positions given the rich reservoir of institutional liquidity. Now, the underwriting group typically encompasses three, four, or more banks, depending on sector and size, and the overall process takes much longer. The situation is a bit better in the EUR200-500m segment, but not much. However, at the end of the day, for the right deal, significant debt quanta can still be found.

Which factors contribute to the higher complexity and slowing down of the process?

Banks now spend far more time with due diligence, to get an even more complete picture of the asset, and everybody needs to make sure that all the t's are crossed and all the i's are dotted, as no one can afford to be caught with a long position on their books. Another factor is that people are hesitant to commit to a firm view of the immediate domestic economic environment: whether we will enter a persistent cyclical downturn or not; and how the global economy develops, which is crucial for Germany as an export-oriented economy.

What, in your view, is necessary to get the market back on track? In your view, could the European Central Bank help alleviate the situation?

The ECB's influence is fairly limited, as its key role is to maintain price stability, not to prop up the LBO market. What the market needs to get back on track is a string of successfully syndicated deals to establish new pricing and process norms.

What type of companies are relisient to current market conditions and are therefore capable of providing dealflow?

Assets that can always be financed are those that generate a lot of cash and have stable revenues with long term visibility, a defensible position of market leadership and limited capex needs. Companies that are vulnerable to a downturn in consumer spending and to the economic cycle can still be financed, but the deal then needs to accommodate this in terms of the debt structure.

Many deals have been sourced from corporate restructurings, as companies focus on their core competencies. For the private equity industry, another important source of deals - and exits - are secondaries, which are partly driven by fund maturity and therefore a structural feature of the private equity market.

Everyone talks of decreasing multiples and increasing equity cushions. Can you put some hard numbers to the sentiment?

We have had to reprice debt, and equity cushions are generally up. One year ago, we regularly saw multiples of more than 6-7x, and comparable deals now see multiples of 5-5.5x, but of course, that number is merely statistical, as each case needs to be seen on its own merits and deserves its own multiple. In one case, we took a more sceptical view on an aggressive business plan, where we had to look at an increased equity stake in the financing.

Equity cushions that used to be in the lower 20s gradually moved up to 30% and kept on rising to sometimes even 40-50% of the total value, but the minimum at the moment is around 30-35%. A typical A tranche is now priced at 275 basis points, whereas it used to be 225 basis points. The blended B/C pricing, which used to be less than 300, has gone up to 400 to 450.

The debt turbulence appears to benefit subordinated debt providers. How has the market affected mezzanine in Germany?

At present, the mezzanine market is far more liquid than the senior market. The increase in pricing has also not affected the mezzanine market as severely, as it can be sold down quite easily, which makes the market more competitive. While mezzanine was a less attractive proposition in the past, private equity houses now invite mezzanine providers from day one to relieve the pressure on the banks, which is not necessarily welcomed, as involvement of third party mezzanine capital can make deals significantly less attractive economically. Mezzanine liquidity comes from both banks and funds. We reckon that while senior liquidity remains tight the mezzanine portion will remain slightly fatter.

What is your outlook for the rest of the year?

We remain positive - we have quite a good flow of deals and have seen a positive turn in secondary market debt prices. Many believe that the worst is over and that all the dirty laundry is now out, and there is still clearly a great appetite to do good deals.

But the situation remains fragile and we anticipate that it will remain a challenging environment well into autumn or the end of the year, partly due to the German 'Sommerloch' lack of activity in summer. We do expect activity levels equivalent to the period 2004-2005, as the drip feed of deals continues, and assuming overall market signals remain positive. After that, we expect a strong start into 2009, when the frozen debt markets should have thawed.

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