Silver Lining

It comes as no surprise that larger transactions are slowing down considerably in the DACH region, due to a dearth of credit. This mirrors the overall European picture: The unquote" Private Equity Barometer for Q1 2008, published in association with Candover, revealed some striking stats. For all of Europe, the first quarter 2008 saw a total of 322 transactions with a total value of EUR21bn - compared to 449 transactions worth a total of EUR56bn in the first quarter of 2007. However, the traditional strength of Germany, particularly in the mid- and small-cap areas, continues to ensure dealflow. Mid-sized transactions are only slightly affected, while small-caps seem unscathed.

The situation in the credit markets has made loans between banks more expensive and has caused a pervading reluctance to lend at all - highlighted in the UK as a series of interest rates cut by the Bank of England have yet to see LIBOR fall. This can lead to the paradoxical situation where a bank has corporate credits at a much lower cost than its own funding costs.

In addition to this, many banks still have long positions on their balance sheets. Many sell this debt at a large discount on the secondary markets, which, according to one banker, shows "that, in these cases, the pressure banks are under must be immense." According to sources, only a few banks have the financial strength to wait things out, and most have to sell the debt off, engendering large book losses without actually suffering cash losses.

In total, risks and opportunities are much more closely examined. While the equity in a deal in the last year was rarely over 30%, we increasingly see equity stakes of significantly above 40% and even up to 50%. With prices still high, IRRs are likely to come down, and portfolio management will require more time-consuming operational improvement.

Unsurprisingly, many banks are now hesitant to underwrite larger debt packages, meaning club deals are on the rise. According to one banker, a deal of EUR500m is now often funded by five or six banks, and even much smaller transactions of EUR100m to EUR120m have two underwriting banks. In syndications, banks are now extremely cautious, selective and conservative, even in considering whether to place the debt on the market at all.

Windows of opportunity

There are some winners, though. With banks increasingly averse to risk, senior debt has retrenched and re-opened a gap for mezzanine to fill. Mezzanine not only has a place in the capital structure again, but with good terms to boot: contracts are being closed that include comprehensive information rights and/or board seats in the companies.

The winners' circle is not limited to subordinated debt providers. "We at Mediobanca benefit from our strong balance sheet and are currently expanding, against the cycle, across Europe", states Thomas Dorbert, head of leveraged finance at Mediobanca. "Tickets have become cheaper, leverage levels are lower, and contract conditions are more friendly for the banks, which enables us to create larger profits with less risk." However, there is no room for a goldrush, cautions Dorbert: "Even liquid banks need to take things step by step and remain selective with transactions."

For many, the current situation sees a correction of market distortions, but leverages have not become totally conservative. It is noticeable, however, that the power balance between private equity and banks has shifted towards the banks, both in terms of risks and profitability of current deals.

The new market environment has also increased the need for advisers' services, where the current backdrop has created a strong demand that encompasses both the structuring of new credits as well as the restructuring of old credits.

The new attitude of banks towards lending means that negotiations are more complex, often going back and forth several times before an agreement is reached. "While we strive for sole underwriting for our clients, this cannot always be achieved. The increase in club deals we are seeing is interesting for advisers as we have the opportunity to build these club deals, but we have to work much harder to assemble them than in the past," states Gerd Bieding of Close Brothers.

While deals are becoming more intricate and time-consuming to put together, the result is still sound: "The deal we have in the end is still a good, solid deal, but it often takes the only possible form, while previously there were many possible alternatives on how to assemble it," Bieding adds. Contributing factors are that many banks are unwilling to finance companies from certain sectors, and banks that are willing to provide debt have longer due diligence processes, more in-depth credit analysis, and keep a constant eye on the liquidity of syndication markets. As a reaction to the changed environment, many advisers anticipate more secondaries as well as a growing focus on developing assets.

Keys to success

Difficulties faced by GPs are exacerbated by the competition from strategic investors, who are rich in cash and whose main concern is not the IRR. "The increase in debt advice reflects the need to act speedily during competitive auctions, as the speed to structure a deal is becoming more of a factor today", states Bieding.

And the dearth in free-flowing credit creates opportunities for banks that escaped the subprime crisis: "As we see it, the key quality is reliability. The worst case scenario for private equity is when banks that have promised to deliver the debt bail out", states Thomas Dorbert.

It is no surprise that domestic GPs keenly observed the Clear Channel case in the US, where Bain Capital and Thomas H. Lee Partners brought suits against the banks reneging on their contract to finance the buyout. Many players anticipate more court cases regarding deals that have collapsed due to the dearth of credit. Apart from the cost of such law suits, the damage to a bank's reputation is immense, and some sources claimed that reliability was in fact far more important than any margin or fee, as banks are partners throughout the deal process and are expected to stand by their word when the deal is concluded.

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