Leverage in 2012: liquidity still a concern

Shrinking liquidity
The leveraged buyout (LBO) market has a history of prospering in times of crisis - taking advantage of the more competitive pricing of target companies and reduced competition from trade buyers. And, without the need for complicated structuring, this can produce strong investment returns.

But transactions are structured and sold down into a market heavily reliant on liquidity and, as the wider economic crisis persists and liquidity further evaporates, activity will undoubtedly continue to be affected into the New Year.

Not only are banks shrinking their balance sheets but collateralized loan obligations (CLOs), a key source of funds, are coming to the end of their reinvestment periods, placing a further squeeze on liquidity.

That said, different credit vehicles are now beginning to target the gaps left by banks and CLOs, and are likely to be a feature of the coming year.

Ongoing volatility
Contracting liquidity will also contribute to a continuation of the high levels of volatility experienced during the past two months - a trait exacerbated by the tendency of the secondary debt and bond markets to track the equity market, creating a vulnerability to the movements of wider financial markets. As a result, a number of buyout deals have been postponed in the approach to year-end.

Certainly, volatility in the severely dislocated bond market has necessitated the use of alternative capital structuring, as seen in the use of mezzanine debt in several large transactions this year despite current perceptions that it is a relatively expensive form of financing. Vendor loans could also make a return.
In the absence of a near-term solution to the ongoing European sovereign debt crisis, such volatility - and alternative capital structures - will certainly continue into the first quarter, and most likely the first half, of next year.

Shifting priorities

This combination of low liquidity and high volatility means buyout candidates will need to demonstrate to private equity sponsors a long track record of successful business in their respective sectors, as well as the ability to provide ancillary opportunities. And in a market where the practical advantages of strong professional associations have long been recognised, good relationships with general partners will continue to be essential.

Also important, and increasingly so, are defensible business models and first-class management teams. Merely maintaining a strong position in the home market will no longer suffice and buyout targets will be expected to have clear strategies for transitioning their businesses towards emerging markets.

It is also likely that the recent trend for investors in LBO bonds to push for greater protection - primarily in the form of first lien collateral, voting rights or improved access to information- will continue. This mirrors the leveraged loan asset class that has continued to perform well despite the crisis.

During previous crises, the buyout market has tended to retreat towards traditionally more resilient sectors such as food, healthcare, telecommunications and utilities. Although this will remain the case, investors are likely to be wary of increasing risk factors such as rising commodity prices, higher technology risk and reductions in government spending. Certainly, the spectre of government cuts has already negatively affected market perception of the defence sector - a sector which had previously displayed steady long term growth.

Upcoming Opportunities
Despite current market conditions, however, banks remain open for business and refinancing opportunities will certainly arise as transactions conceived during the market's peak, prior to the Lehman crisis, start to reach debt maturity.

Furthermore, increasing economic pressures in some sectors will induce corporate groups to spin off subsidiaries as they seek to deleverage. And many sponsors will be keen to source new funds, raising the prospect of a reasonable secondary buyout deal flow in the year to come.

There is reason, therefore, to greet the New Year with a measure of optimism, despite the shortage of liquidity and ongoing volatility that is likely to mark the early months.

Graham Olive is Head of Acquisition & Strategic Finance for Northern Europe at Natixis.

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