Keeping leverage in check

For many years following the financial crash, access to financing topped the list of GPs' concerns and was frequently cited as the main factor behind the delayed rebound in activity. The past 18 months have certainly put paid to what was increasingly being seen as a convenient excuse for lacklustre dealflow: the financing market heated up consistently throughout 2013, boosted by an influx of liquidity stemming in no small part from increasing appetite from institutional investors for credit products.

Intermediate Capital Group (ICG) is one of the many players that benefited from this strong demand, which has, in turn, allowed it to offer more financing options to private equity houses and European businesses alike. The debt investor notably closed a sizable mezzanine vehicle, ICG Europe Fund V, on €2.5bn at the beginning of last year. And, just a few weeks ago, the group announced the final close of its senior debt-focused, direct lending fund Senior Debt Partners I on €1.7bn, comfortably exceeding its €1bn target. According to Dagmar Kent Kershaw (pictured), who heads ICG's credit fund management operations, investor appetite for debt products shows no sign of abating: "Investor demand for direct lending vehicles has only increased over time. Even though our fund has closed, we have seen a steady stream of investors who already want to know when the next vehicle will be raised."

ICG has certainly not been alone in benefiting from this trend, which is viewed by some as the first step towards a US-style financing market finally crossing the Atlantic – in the US, more than half of all loans originate from non-bank lenders, while in Europe, banks have so far provided the lion's share of financing. Last year saw Rothschild holding a first close on €235m for its Five Arrows Credit Solutions fund, Idinvest raising €281m for its Dette Senior Vehicle, CVC Credit Partners placing shares worth €350m for its listed debt fund CVC Credit Partners European Opportunities, and HIG's credit arm Bayside announcing a $1.1bn final close for its latest European vehicle – all in the space of a few weeks in Q2.

Open the floodgates
And it is not just alternative lenders that have been able to suddenly fuel the market with more plentiful and more bespoke financing options. "There is a theme running from the mid-market to the larger segments and the high-yield space, of excess demand over supply," says Marlborough managing partner Jonathan Guise. "That, in combination with macroeconomic stability and genuine evidence of economic recovery, has meant the market has become increasingly borrower-friendly."

A quick glance at Marlborough's research on European debt markets in 2013 indeed shows most curves moving sharply upwards in the past few months. At an overall €67.4bn, new loan issuance was up by 136% on 2012 – making 2013 by far the most buoyant year for the leveraged loan market since the 2009 nadir. The growth in the high-yield market, meanwhile, does not even suffer by comparison with a pre-crisis peak: at €70bn, including €26bn for sponsored placements, last year's total issuance on the European market easily dwarfs the €23bn recorded in both 2006 and 2007.

Looking at the number of deals involving unitranche financing – by far one of the most talked-about alternative debt sources in recent months – also reveals a 166% surge between 2012 and 2013. If the first months of this year are anything to go by, this trend should easily carry into 2014: recent refinancings and acquisitions that comprised a unitranche element include Groupe Looping (€30m from Alcentra and BPI France), Mec3 (€80m from ICG), Dorc (€110m of unitranche, working capital and acquisition finance from Ares and GE Capital) and NoteMachine (£76.5m, again from the Ares/GE duo) among others. Given this fierce competition from alternative lenders, banks – which have for so long been portrayed as retrenching from the market under the weight of more stringent capital requirements – have also had no choice but to come out and play.

The borrower is king
The relative paucity of attractive transactions into which the masses of liquidity in the debt market can flow means the supply/demand imbalance mentioned by Marlborough's Guise was further skewed as 2013 went on, resulting in increasingly borrower-friendly pricing and terms. The average yield to maturity for term loans B, for instance, declined steadily throughout 2013 to hit a record low 4.52% in Q1 this year. The trend is expected to carry well into the rest of 2014, with recent research by DLA Piper showing that market participants anticipate pricing for senior debt to continue its decline: 60% of the 250 players surveyed in the firm's Acquisition Finance Report 2014 expect senior debt margins to stand at less than 4% this year, against just 11% anticipating sub-4% margins in the 2013 survey.

The high-yield market has also been offering increasingly attractive financing options for GPs eager to either refinance portfolio companies with more favourable structures, or strike a good balance between affordability and constraints on the business for new deals. Coupons have fallen steadily in the past 18 months, with European single-B bonds yielding around 7.2% on average in Q4 last year, around a percentage point less than in the comparable period in 2012. Judging by some of the recent record-low issuances – LBO France's Labeyrie placing €275m of senior secured notes with a 5.6% coupon at the end of March comes to mind – this window of opportunity does not show clear signs of closing down either.

Add to that the competition among alternative lenders to deploy the large amounts of capital flowing from debt-hungry investors, and overall leverage ratios have, not surprisingly, crept up. According to Marlborough Partners' research into the debt market, average European debt/EBITDA ratios hovered around the 5.1x mark in the first quarter of 2014. But the potential sign of a market heating up lies in the outliers rather than the average – with some debt packages, such as that recently put together for the refinancing of private equity-backed Ceva Santé Animale, exceeding the 7x EBITDA mark.

Pricing and structures aside, lenders are also increasingly feeling the squeeze when it comes to terms and conditions. Last year's Mergermarket and Ceramtec deals, sponsored by BC Partners and Cinven respectively, acted as a first breach in the market's hitherto strict attitude to covenant-lite deals. But these transactions saw the sponsors tap into the US lending market, traditionally less reluctant to relinquish the security afforded by stricter covenants.

On the other hand, the aforementioned refinancing of Sagard's Ceva Santé Animale earlier this year stood out as the first fully European cov-lite deal since the financial crisis. The business secured around €800m from Credit Agricole, Natixis, Nomura and Goldman Sachs, with the fresh facility understood to eschew debt-to-earnings ratios and including a payment-in-kind (PIK) element. Although incredibly favourable for the business itself, the new structure raised many an eyebrow across the continent.

The return of cov-loose and cov-lite structures, combined with the aggressive leverage ratios seen on some refinancings and new-money deals in recent weeks, have led some market observers to express concerns; earlier this year, KKR's Henry Kravis himself urged his fellow investors not to get carried away and keep the potential strain on businesses in mind. Is the industry back to the bad habits of the 2005-7 boom years, when packages in excess of 7x EBITDA were the rule rather than the exception?

Lenders and debt market specialists are, so far, confident that the situation remains manageable. ICG's Kent Kershaw highlights that the market cannot be painted with the same brush: "In the mid-market, direct-lending space, we are not seeing the same pressure on pricing and terms compared to the larger end of the market - in the latter, the supply/demand effect is more prominent and it is much harder for a single lender to actively shape the terms and conditions, so we are seeing more pressure on structures and looser covenants," she says. "On the other hand, credit discipline has been by and large maintained in the mid-market, since it is more illiquid, without the ability to trade in and out of assets as easily."

Even at the top end of the market, overly aggressive structures remain few and far between, argues Ian Brown, managing director and head of acquisition finance at Lloyds Bank Commercial Banking: "We have seen a few cov-loose or cov-lite deals, and total leverage ratios of 6-7x EBITDA are now being seen on the larger deals. But the underlying interest rates are very different and so are the structures: we are not yet seeing some of the excesses of the boom years, such as packages of multiple tranches with PIK on top."

No comparison
The theme of a current market environment being markedly different to the 2005-07 era is also one that resonates with Olivier Berment, co-head of the private debt activity at one-stop-shop Ardian – which has played no small part in fuelling the market, deploying more than €1bn in unitranche financing over the past couple of years. "Comparing the current market to 2007 is wrong for several reasons," he says. "The main thing is that equity cushions are just as important to consider as overall amounts of leverage. In 2007, it was not rare to see deals financed with just 25% of equity. Nowadays, equity is still a minimum of 40%, even for those deals where overall leverage seems high. Lenders will always look at that buffer from a distressed scenario perspective and having 40% of equity above you is a good cushion." He adds that the "flight-to-quality" phenomenon that sees GPs parting with large sums of cash only for the best assets also applies to lenders' willingness to contribute to aggressive structures and pricing: "We are really talking about the best of the best. In 2007, we would have seen similar structures put in place for businesses that are much less resilient, which could indeed be cause for concern."

If anything, the dry spell experienced by sponsors and businesses in need of financing solutions in the years immediately following the crash might have distorted the perception of today's market, says Kent Kershaw: "Yes, terms have changed at the larger end of the market, but from what? We have been in an environment for a number of years where pricing and terms were very lender-friendly. So while terms have changed and covenants have loosened, they have done so from post-crisis levels that were unprecedented with regard to conservative structures and extremely attractive pricing from a lender's perspective."

While industry participants seem adamant that the lessons from the past will not be forgotten, some point to the potential risks if the supply/demand imbalance persists for much longer. "At the moment rates are so low that the coverage statistics are very strong. That said, if demand continues to outweigh supply for a long time, then it is inevitable that structures will become increasingly aggressive," warns Marlborough's Guise. Lloyds's Brown agrees that there is always a danger that leverage continues to increase and structures become more complex to cope with this phenomenon. "We are a long way from it being of real concern at this stage, but we are certainly attuned to the potential risk," he says.

Show me the (new) money
This is, of course, dependent on two different trends, one being whether liquidity keeps flowing into the market in the coming months. While most industry players expect the honeymoon to continue well into 2014, as evidenced in DLA Piper's debt survey, many factors have to be taken into account to assess how readily available leverage will be. "Regulation is key, as are wider macroeconomic risks that are tough to predict," says David Miles, head of debt finance at DLA Piper. "The tapering of quantitative easing is also something to keep an eye on, but our understanding is that it should mostly affect the larger end of the market without significant impact on the bulk of private equity deals."

Brown also sees few clouds on the horizon when it comes to the availability of financing: "At present, we see no reason to believe that debt financing will be negatively impacted in the coming months. The markets remain very robust; global events, such as the ongoing situation in Ukraine are having hardly any impact on the indices and the UK economy is maintaining its positive position, so the horizon holds no obvious concerns at this stage."

But the other deciding factor as to whether aggressive pricing and structures will keep escalating to a potentially uncomfortable level lies with appetite on the deal-doing side. Lenders' eagerness to put money to work stands in stark contrast with research highlighting the delayed recovery in private equity dealflow across Europe. After all, statistics from unquote" data show that the overall value of leveraged buyouts in 2013 remained stable at around €75bn, while deal volume decreased by around 10%.

Indeed, last year's impressive loan and bond issuance statistics hide the fact that a large part of this was down to refinancings. This is good news, given the alarmist headlines two years ago warning of a "wall of debt" catastrophe in the making. "The 'wall of debt' is really nothing more than a 'step' now. CLOs and the high-yield market have chipped away at it month after month – and some GPs were particularly proactive at tackling their refinancing schedule," says Brown.

But this also means the abundance of refinancing efforts is likely to taper off and it is not clear whether the more favourable market conditions expected across most European markets in the remainder of 2014 will translate to more new-money deals, easing the pressure on pricing and terms. "There is still a reasonable amount of refinancing activity at the moment, but there is not a lot of primary activity as yet. So the jury is still out when it comes to what 2014 will look like: we might end up with less overall activity on the debt financing front as refinancings are unlikely to be as prominent compared with 2013 as the year progresses," says Miles.

Addressing the supply/demand imbalance via a natural market readjustment might be the best way to ensure the excesses of the boom years stay a thing of the past. Bar any improvement on that front, continued self-discipline from both financial sponsors and lenders will have to remain the best alternative.

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Send to  

• Topics
• Financing
• Acquisition finance
• Senior debt
• Top story
• Intermediate Capital Group
• Marlborough Partners
• DLA Piper