Trouble brewing

This feature is taken from Private Equity Europe, the pan-European publication from the publishers of unquote")

Buyout deal volume in France dropped by over half from January 2008 to June 2008 in comparison to the same period last year, as firms struggled to put money to work in light of the restricted liquidity in the market. The problems afflicting France are, of course, being felt across Europe, but these problems are also happening at a time of wider debate regarding the place of private equity in the French economy.

Management packages

The issue of management packages and the level of remuneration has been an ongoing one for many months but it was thrust back into the spotlight by Dominique Senequier, head of AXA Private Equity, who suggested that France’s labour code should be amended to oblige private equity firms to distribute 5% of the capital gains from companies they sell among all employees. She has since back-tracked slightly and called for a voluntary code to govern the distribution of capital gains, yet sentiment is turning against private equity in a country which has thus far avoided the sort of vitriolic debate seen in the UK last year.

Senequier’s comments were in part prompted by the news that the management team at power generation company Converteam is set to pocket around €700m from the sale of the company by Barclays Private Equity to LBO France. The formerly loss-making Converteam was returned to profitability by management and the financial rewards reflect the terms written into their contracts at the time of the original deal. ‘Management often has significant financial requirements which do not always stick with the sponsors’ goals, it being recalled that, in France, the management package is a key issue in most private equity deals. This year the levels have been more reasonable although the debate has started again,’ says Olivier Deren, partner at Paul Hastings.

Patrick de Giovanni, partner at Apax, believes that ‘the packages are not an issue on the primary LBO, but as you move on to the SBO, tertiary or quaternary deal, management’s expectations rise in turn.’ Converteam was an unusual case in this respect, as the rewards to management were so lucrative that LBO France is reported to have had difficultly incentivising them to stay on under the stewardship of the new investor.

T&C’s

Regardless of management rewards, the deal was a sign that although liquidity is not as abundant as it was last year, banks are willing to lend against businesses they are comfortable with. The difficulty, says Olivier Boyadjian, managing director at H.I.G Capital, is that, ‘it is not easy to find very good assets in the current market but it is only for first class ones that you can arrange a decent debt package.’ He adds that it is ‘not really an issue for us at H.I.G. since we have secured our own credit line to finance our equity transactions.’

Even for first class assets, negotiating a package is more difficult in the current environment. ‘Due diligence requested by the banks is more thorough. Terms and conditions have also changed. Debt multiples last year were around 7x EBITDA for the senior debt. This has come down to around up to 4x. The equity contribution demanded by banks has also gone up from 20-25% last year to a minimum of 40% now,’ says Deren.

The increased scrutiny has resulted in banks establishing new committees to ensure they have full visibility on a potential deal, according to Michael Diehl at Activa Capital. ‘Arranging financing is a slow and time-consuming process. Not only do you have credit committees, you now have sector committees and liquidity committees to get through.’ Boyadjian says that the internal power structure in bank committees has shifted as a result of the credit crunch. ‘From 1999-2007 the power went from the risk manager in a credit committee to the syndication executive who didn’t care about risk, he cared only about selling on the debt and the margin he could make on the sale. During these years bankers weren’t bankers. Bankers were salesmen. Bankers have now gone back to being bankers.’

Bankers may have gone back to the traditional business of identifying and managing risk, but as there are fewer of them in France than in other countries this is causing problems says Christiian Marriot, director at Barclays Private Equity. ‘Debt market corrections have had a more pronounced effect in France than in the UK or Germany as the pool of potential lenders is not as deep.’

Staple finance

The Converteam deal appears to have bucked the prevailing trends in the debt market. The club of banks, comprised of HSBC, Lehman Brothers, Natixis, Société Générale and Royal Bank of Scotland, provided a staple financing package, an unlikely move in an uncertain environment. Staple finance has typically been used as a tool by vendors to speed up a sales process and provide greater certainty for all parties involved on a deal. And as the package sets a benchmark for potential competitor offers, the terms offered by the bank (or banks) are usually aggressive. For the bank, arranging fees, a one-off fee for offering a stapled package and possibility of further business are reason enough to structure such a package to offset the generous terms. However, with liquidity scarce, staple financing may make even greater sense. With few other providers in the market, the bank no longer has to offer such generous terms, and as such the buyer would be taking a risk turning it down. Yet it still provides the certainty of execution which is crucial in today’s environment and brings in a healthy fee. In the Converteam case, the size of the deal was such that it would have been difficult for the buyer to find alternative financing to the offer on the table. According to Romain Cattet, senior vice-president in debt advisory at investment bank Houlihan Lokey, there is still appetite at those banks which aren’t over-exposed to LBO debt and this is helping to drive staple finance offerings. ‘The reason why banks are agreeing to underwrite staple financings is because they know they can syndicate it to the local banks.’

As has been the case in markets across Europe, vendor price expectations in France have been slow to adjust to the changed climate. However, whereas in the UK this remains the number one complaint from buyers, in France expectations are beginning to shift, according to Didier Riebel at NBGI Private Equity. ‘At the beginning of the year it was the case that higher valuations were being sought but now we are into the second half people are more conservative and multiples are starting to reflect the pessimism. There is a realisation that the real economy is being affected whereas before it was seen as a financial market problem.’

NBGI recently opened an office in Paris and will focus on small-cap buyouts. Laurent Allégot, who heads up the Paris office along with Riebel, explained the rationale. ‘As the traditional players in this segment have moved up to the mid or lower-mid market competition has decreased and there are good opportunities to invest. This space has also been less affected by the credit crunch and you can still get access to debt.’

Public markets

The French public markets have rarely been a good source of deal flow for private equity firms because of the onerous take-private regime. Michael Diehl at Activa Capital says that ‘the 95% squeeze-out rules make public-to-privates difficult to complete, and it’s been a disappointing year for P2Ps with only two announced to date.’ Indeed, according to unquote’s proprietary database Private Equity Insight, there were a mere six take-privates in France last year in comparison to fifteen in the UK and as Diehl mentions there has been just two this year, the delisting of Leon de Bruxelles and Abenex Capital’s acquisition of design and outfitting business Réponse Groupe. In comparison, there has been eleven public-to-privates in the UK since the turn of the year with a couple more in the pipeline awaiting completion.

The arduous take-private rules may have deterred delisting attempts in France but the appetite among private equity houses for publicly listed companies remains, as the trend for minority investment deals shows. There has been a raft of such deals in the past year and with public company valuations showing little sign of sustained upward movement, the trend is likely to continue. ‘We are tracking the public markets as in many cases the price doesn’t reflect the true value of a company,’ says Allégot. With valuations struggling, corporates are re-focusing resources on their core business, leaving private equity well-placed to capitalize on potential non-core divestments. ‘Big corporates have strong balance sheets but in the current environment there is naturally a push to focus on core business and corporates will be looking to sell non-core assets in the coming months,’ says Diehl, whose firm has significant experience of backing spin-offs from larger parent groups.

Taking a minority stake in a private company is also a route likely to be pursued by private equity firms in the coming months. Activa recently acquired a 37% stake in sports retailer Sport 2000 but has bought only the central purchase warehousing agency of the company so is immune from direct retail exposure through the chain of stores operating under the Sport 2000 brand. This is an innovative model and may be one that other firms look at in order to put money to work whilst hedging their exposure to sectors most at risk from the economic downturn.

Labour laws

A peculiarity of the French market, and one which may hinder the ability of private equity to tackle portfolio company problems, is the difficulty of removing management and bringing in new blood due to the protection afforded to incumbent management by stringent labour laws. ‘There is a different vision of the position of management in France compared to the UK. There is less mobility and people change jobs less frequently,’ says Jacques Brun, vice-president at Celerant Consulting. He says that difficulty removing management due to the legal environment is only part of the problem as, ‘it is also difficult to find the right people if you are looking to appoint new management.’ Brun also suggests that the weakening economic climate will ‘make the relationship between management and the private equity sponsor tougher as the private equity firm will have to get more hands-on and involved in the decision-making process.’

Although there has yet to be a high-profile failure of a private equity backed company in France, Cattett issues a sobering warning. ‘There are a number of over-leveraged, under-performing companies out there and a default wave is coming – what we don’t know is how big it is going to be and how the banks will react,’ he says.

Good and bad

While there is little doubt that companies are struggling with headroom issues and private equity firms have significant work to do to avoid defaults, it is not all doom and gloom.

Marriott says that, ‘assets are still being bid for aggressively and going for serious multiples and we are also seeing competition from firms moving down the size bracket to get deals done.’ Volume and value may be down but deals are getting done and foreign banks are stepping into the space left by the traditional financiers. A French buyout house confirms that a recent mid-market deal it completed was financed in part by a senior tranche provided by the Portuguese bank Banco de Sabadell and although the traditional French lenders are less active, they still have an appetite. According to a source, there is a deal currently in the market with a debt multiple around 7x EBITDA and the banks arranging the debt package include Société Générale, Crédit Industriel et Commercial and BNP Paribas as well as GE Commercial Finance, Fortis and Barclays.

Boyadjian, however, cautions against over-optimism. ‘Around half of LBO’s completed in 2005, 2006 and 2007 are going to be facing covenant issues before year-end and many will arrive at their third set of ‘bad’ covenants after the holiday period. There is a significant amount which have already breached the ebitda/leverage covenant but few, as of yet, that have breached the cash covenant.’

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