Acquisition finance: breaking with tradition

Despite bringing much needed liquidity and competition to the debt market, many GPs are still wary of alternative lenders. Here is our continued investigation into the differences between traditional and alternative lenders. 

Click here to read the first instalment.

Relationship banking
Arguably, the heart of private equity is relationships; the deep alignment between LP, GP and portfolio company CEO is what gives the asset class its edge against other forms of investments. And when it comes to acquisition finance, relationships remain a key feature.

Relationship banking was the norm until the financial crash, meaning what was agreed with the GP's counterpart at the bank was what was delivered on the day. However, following the downturn, credit committees have slowly severed that bond.

According to Ian Sale, a managing director in Lloyds Bank Commercial Banking's acquisition finance team, relationships are still key: "Relationships are very important for all banks, especially with private equity houses, as we are keen to obtain repeat business from them over many years."

Dougal Bennett, a partner at Dunedin, agrees: "Yes, relationships with the banks are meaningful. It used to be that you would know your counterpart in the bank and that tie offered reassurance. However, the trust has been dented by credit committees going back on deals. But we are getting to the point where trust is being rebuilt. When the individual trust is there, it brings confidence to the deal and the relationship is very important."

However, in the UK alone debt funds are sitting on £10bn, and are currently raising another £5bn, according to Deloitte. With this immense war chest to deploy, alternative lenders are well aware of the importance of relationships in private equity. "The market for private equity firms seeking debt solutions is efficient," explains Anthony Fobel, partner and head of private lending at BlueBay Asset Management. "To ensure we get the call from debt advisers or banks or various types of intermediaries, we work on those relationships. We also build direct relationships with private equity houses; we are aware of their portfolio companies and upcoming deals, and make sure that we are in close contact so that we're considered when debt is next needed."

The great unknown
Strong and trustworthy relationships also offer a level of comfort for GPs regarding the portfolio company's future performance. A major concern held by private equity over alternative lenders is how they will behave if something goes wrong or the company needs more cash for growth.

The main problem is that alternatives have an extremely limited track record. Says Sale: "Unitranche offers more headroom on covenants so the business really has to under-perform to default. But, this hasn't been tested yet."

"You have to know how organisations will react in good and bad times," says Bennett. "You might need more money to support growth or the company might be struggling with repayments." It's for this reason that many GPs prefer lenders to have expertise in the sectors they lend into. "If a bank knows a sector well, it will understand the external factors that may affect businesses in that sector and therefore it may be less concerned if a company encounters difficulties," adds Bennett.

DC Advisory managing director Jonathan Trower's belief is that these lenders must act commercially: "Alternatives need to survive so they need to be aware of their reputation. It all feeds into their overall track record for when they raise new funds."

Fobel echoes this sentiment: "Where a business needs refinancing, we're happy to do that," he says. "Because we provide a bi-lateral loan, which we hold until maturity, there is no fear that we will trade the loan. We try to have a partnership approach with private equity so if any issues do arise we can be part of the solution."

When it comes to providing further cash for growth, Fobel raises an interesting point: "Banks don't like lending further as they have to set aside capital to do so because of Basel III. We don't have that restriction."

What next?
Whatever the industry thinks of these new entrants, they have brought more choice and liquidity to a once desert-like market, resulting in increased competition and therefore making terms and fees more attractive.

But, as with any third-party provider, the final decision will come down to what's best for that particular asset. As Sale points out, senior and unitranche are different products and can't be compared like-for-like. Furthermore, alongside the rise of unitranche loans has also been the proliferation of asset-based lending and invoice discounting, which can often be the optimal debt solution for smaller companies.

As unitranche becomes more commonplace for acquisition finance, will the European private equity market start to resemble that of the US, where the majority of deals are funded by alternatives? It is hard to imagine Europe relinquishing its dependence on banks but it is not too difficult to envisage a market where banks return to providing the ancillary products, thereby moving away from mountainous piles of debt, in line with how the regulators would like them to behave. This would leave a neat space for credit funds to fill, which in time will benefit institutional investors thanks to the impressive returns these are able to deliver. We are already starting to see the shift with last week's announcement of a partnership between Barclays and BlueBay.

The answer will come in due course. Alternative lenders need time to build up a much-needed track record and show the industry how they react to unexpected performance, what happens when the loan reaches maturity and, most of all, their true colours.

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