Adjusting to the new paradigm

In July last year there were around 20-25 banks lending to the mid-market. This fell to around a dozen in the last quarter of 2007 and now stands at just a handful. Awash with liquidity this market most certainly is not. Buyout houses are now adjusting to a new paradigm in which debt is scarcer and more expensive.

When the credit markets contracted drastically last year, some were hopeful that it was a short-term crisis. We now know that the credit crunch represented the beginning of an altered environment that looks set to endure well into the medium term. “The good thing is that buyout players are awash with cash and want to do deals,” says Neale Broadhead from Lloyds TSB Corporate Markets. Lloyds TSB is firmly open for business along with the other UK clearing banks, and some others - GE Commercial Finance, National Australia Bank, CIT Capital Finance, and the Irish Banks. “These adverse market conditions have presented a real opportunity for the UK clearing banks,” believes Adam Freeman from Linklaters, “Previously the large buyout players would have primarily dealt with the big investment banks but now the HSBCs, HBOSs and Lloyds of the world are coming into play.”

Mega-deals are off. Although a number of EUR 1bn+ deals have completed since the credit crunch including First Reserve’s acquisition of Abbot Group and the Apax/GMG buyout of Emap’s B2B division, Freeman believes that since December the market has become even tighter. The mid-market, however, continues to be active but the landscape has materially changed.

Front end syndication

The inability to syndicate to an institutional market has created a paradigm shift within the leveraged buyout market. The market is now defined by the prominence of club deals. “Club deals are essentially a means of front-loading the syndication process,” explains Chris Jackson from CIT Capital Finance. Leverage has come down significantly and “what would have been 8x last year would be 6.5x in today’s market,” says Broadhead. He also says that although the terms are not as attractive, the ability to get cash to work is the over-riding concern for buyout houses. A rebalance of power is in train. Where previously the buyout house was in a position to demand equity cures and financial mulligans, it now has to borrow money on the banks terms. The club deal itself creates an issue for sponsors which they would not have had to face last year - in that banks refuse to be exclusive to them. “In today’s environment, the number of lenders open for business is much smaller than it was before the crunch and when compared to the number of sponsors looking to do deals,” says Freeman.

With the number of players reduced, higher priced debt and an atmosphere of caution dominating, there has been “a flight to favoured relationships,” explains Ian Bagshaw from Linklaters. Where banks want to maintain relationships, they will pull out all the stops.

Suggestions that in lieu of debt, private equity groups may seek loans and funding from sovereign wealth funds contrasts with this flight to relationships. It is reported that the big buyout houses are already in discussion about directly co-investing with sovereign wealth funds where they can’t obtain debt. While this is a possibility and represents the manifestation of an imagination that these contracted conditions call for, this sort of strategy is likely to confine itself to large cap deals. Additionally, the returns on offer for the sovereign wealth funds means it is likely to be a short-lived expedient. “There is a nervousness from the equity point of view about who you are getting in to bed with,” says Broadhead, “In what could be potentially difficult trading times for businesses, buyout houses will want to tap their friends for debt rather than groups they don’t know.”

Mezzanine resurgence

In contrast to the scarcity of liquidity in the senior debt market, the market for mezzanine finance remains fluid. “Mezzanine has come back in full force and second lean and PIK are so last year,” confirms Broadhead, “There are a lot of institutional takers for it.” Second lien and PIK instruments kicked mezzanine to the wayside, giving it the characteristics of cheaply priced senior debt without its more comfortable risk profile. But now with second lien and PIK options firmly off the menu, sponsors are hungry for the mezzanine diet. Buyout players need mezzanine tranches to get their deals away and the terms of the product in the post-credit crunch environment reflect this. “The market for mezzanine debt at today’s pricing levels is buoyant,” says Jackson.

Out-maneuvered over the last few years by new pieces of debt which gave rise to pricing and warrant erosion, mezzanine providers have still been putting cash to work. The post-credit crunch environment has, however, shifted the point of contact at which the mezzanine house gets involved. European Capital’s Nathalie Faure Beaulieu explains that before the credit crunch, the mezzanine provider had less access to a sponsor in the mid-market than currently. Mid-market sponsors were previously able to source their entire debt requirements from one party. This is now more difficult, “We are now seen as much more valuable as we don’t have syndication requirements and therefore have the ability to deliver and then hold the mezzanine strip,” says Faure Beaulieu, “This has given us access to the sponsor at the beginning of the process. We are now in a stronger position and work with the sponsor throughout the due diligence process.”

Independent mezzanine providers are now exposed to the execution risk of deals but this is a small price to pay in return for more acceptable terms and conditions on the paper and the ability to raise issues with the deal do-ers as the due diligence process takes place, instead of being part of a huge syndication group with no such say. “The liquidity in the mezzanine market is now showing itself and it is being used to shore up deals,” confirms Freeman.

The credit crunch has opened doors for independent mezzanine houses as banks are now not always willing to provide both the junior and senior parts of the debt structure. However, the re-emergence of the mezzanine product is not something they are willing to miss out on. CIT recently underwrote a debt package for Balmoral Capital’s first UK buyout which comprised both senior and mezzanine debt and it is not alone.

Banks’ appetite for mezzanine, a product thought to be past its sell-by date just nine months ago, is being accompanied by bank appetite for equity on deals. Many banks have divisions or principal finance organisations which can acquire equity stakes in businesses and this activity is set to increase in order to help shore up deals and generate higher yielding money from more creative investing. Barcap’s stake in supermarket chain Somerfield which it acquired in a £1.1bn deal led by Apax in late 2005, is an example of this. Most recently, Goldman Sachs took a minority stake in sandwich chain Prêt A Manger.

Today’s market is a different beast than last year’s. There is much speculation about the different funding possibilities available to private equity to enable it to continue going about its business. The likelihood is that equity-only underwrites and debt from sovereign wealth funds will remain on the sidelines. The formula that the industry has developed to generate great returns will endure and in these trying times it will rely on its patience, know-how and long-term relationships with debt providers to see it through.

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