How private equity is dealing with the debt deluge

Carlyle's carve-out of data storage firm Veritas from Symantec is no longer most notable for being 2015's largest leveraged buyout.

Struck in August, the deal was derailed when underwriting banks were unable to syndicate the $5.6bn debt package backing the deal to investors, which baulked at the company's subsequent waning performance and the structure's high leverage. In January, Carlyle renegotiated $600m off the original $8bn asking price to get the deal away. A number of large-cap buyouts have suffered the same fate, with underwriting banks struggling to sell down loans in the face of wider market uncertainty.

For the very largest private equity transactions, Europe has not been immune. Today, the same investor buys loans and bonds - and on both sides of the Atlantic. This convergence has meant that when the debt capital markets shut for mega-deals in the US, to a greater or lesser extent, they also close in Europe. Just as stock markets in both regions have slipped, so too has appetite for risky leveraged loans.

All those that were perceived as good credits did well and all those that were seen to be on the edge were torn to shreds and got flexed out of the wazoo, or couldn't get done. There is nothing in the market at the moment, which is very unusual and that's bond or loan" - David Parker, Marlborough Partners

"It's what you always see when markets get nervous," says David Parker, a partner at debt advisory firm Marlborough Partners. "There were a tonne of deals in the market because of the hangover of deals that were underwritten in November and December that came to market in January. All those that were perceived as good credits did well and all those that were seen to be on the edge were torn to shreds and got flexed out of the wazoo, or couldn't get done. There is nothing in the market at the moment, which is very unusual and that's bond or loan." He adds that Marlborough is currently advising on only one large-cap deal and 15 mid-market transactions, when bumper buyouts typically account for around 30% of the firm's business.

However, moving down the deal spectrum, away from fickle capital markets, Parker and others stress that it is an altogether different story. The mid-market is flush with liquidity. European direct lending funds have $41bn at their disposal, according to data provider Preqin; twice as much as in 2012.

"If you look at the bigger-ticket market, highyield bonds and syndicated loans, it has been very volatile in Q1 this year. Secondary prices have been yo-yoing and we expect that to continue for the next six months," says Floris Hovingh, head of alternative lender coverage at Deloitte. "But if you look at the mid-market there are more than 60 nonbank lenders in Europe looking to deploy cash on borrower-friendly terms, so that continues to be an extremely buoyant market."

According to Hovingh, roughly half of mid-cap private equity deals (in the £10-40m EBITDA range) in the UK are being financed by non-bank lenders, with 53% of this financing accounted for by unitranche, the alternative financing product of choice. By contrast, senior debt comprises 30% of non-bank lending. Moreover, across Europe alternative lending was up 9% on a volume basis in 2015, according to Deloitte's data.

Shoring up the banks
Meanwhile banks, which still account for the majority of the leveraged financing market in the UK and Europe, are defending their lot. "The turbulence in the US is flowing into Europe, but the mid-market seems to be weathering the storm, in part because of a dearth of larger transactions, coupled with increased competition and appetite from traditional banks and non-bank lenders to provide credit to borrowers in that space," says Tim McKean, director and head of Stevenson James's debt practice. "Direct lending funds have significant capacity to lend, while the banks are attempting to protect their market. After all, this is their core bag; for these SME borrowers, midmarket deals are their bread and butter."

Not only do banks want to continue lending senior debt on private equity deals, but doing so gives them a foot in the door to offer wholesale corporate debt facilities, from working capital to capex. Lending on buyouts helps to forge relationships that are far harder to establish by cold calling or anonymously knocking on companies' doors.

Banks have been forming alliances with direct lending funds for this same purpose. RBS announced in December that it was teaming up with asset managers Hermes, M&G and AIG to lend into midmarket leveraged finance, while a tie-up between GE Capital and Ares was cut short when General Electric sold its bank, and Barclays has aligned itself with Bluebay Asset Management.

Such partnerships ensure that banks have opportunities to offer ancillary products including revolving credit facilities that funds themselves are not set up to provide. Moreover, the banks can negotiate super-senior tranches of debt into structures that can help to make debt packages more competitive for sponsors.

Bite the bullet
Ian Sale, managing director of acquisition finance at Lloyds Bank Commercial Banking, says high-street lenders have also made concessions on loans to more closely reflect the repayment profile of the unitranche product provided by direct lending funds: "Banks have adapted in response to funds by offering more bullet repayments on loans and less amortisation, and are actively working alongside the funds by providing super-senior facilities and also first-loss/second-loss tranches. Unitranche is still perceived as expensive at times compared to vanilla senior debt, but the product can suit certain situations."

While banks charge in the region of 450-600bps over the cost of funds, unitranche providers can expect anywhere north of this. However, the lack of amortisation on the product means that GPs may be willing to swallow the extra cost if they are looking to channel company cash flows into roll-outs without the worry of debt repayments until their loan expires.

There are other advantages. In December, Eurazeo acquired Fintrax, a provider of VAT refunds to international travellers, from Exponent for €585m. The deal was largely financed with a €250m unitranche loan from Ares, marking what is thought to be the largest bilateral direct loan in Europe to date and a clear sign that funds are moving up the chain to finance larger deals.

Edouard Guigou, a deputy director at Eurazeo, who worked on the deal, says the direct lenders who looked at the situation offered more flexibility in the financing documentation in terms of maintenance covenants, cures and baskets: "It wasn't a cov-lite deal, it's just that they required fewer covenants. In particular, they gave us more headroom in case of short-term shocks. Fintrax is very much linked to tourist flows and the holiday and travel sector can be impacted by unforeseen events."

With an average direct loan moving from the €125m mark two years ago to €250m today, these funds are expanding their coverage. Indeed, 85% of those polled in a recent debt survey by DLA Piper believe alternative lending funds will look to invest in larger transactions over the next year. And while they are competing against each other in a bid to entrench their brands, collectively they are also attempting to grapple market share away from the banks.

If you're a sponsor, you could do a syndicated loan, but at the moment you don't know where the pricing is or how much you're going to get flexed; the documentation terms might get changed through the flex. Alternatively, you have these direct lenders who maybe you do not know so well, but there will be no flex rights and it is a done deal" - Mark Donald, Weil Gotshal & Manges

According to Mark Donald, head of the London banking practice at Weil Gotshal & Manges, by clubbing together they can extend their reach out of the mid-market. "Direct lenders are really stepping up and are starting to say that they can club together to do a €500-600m debt package. That's a large-cap deal. We are at an interesting point in the market where we will see whether direct lending funds can do that," says Donald. "If you're a sponsor, you could do a syndicated loan, but at the moment you don't know where the pricing is or how much you're going to get flexed; the documentation terms might get changed through the flex. Alternatively, you have these direct lenders who maybe you do not know so well, but there will be no flex rights and it is a done deal."

It's easy to overstate the role of direct lenders in Europe. While they have taken considerable market share in the past three years as banks have deleveraged and come under tighter regulation, they are still in the minority. In the UK, non-bank debt accounts for an estimated 28% of all corporate lending and this falls to just 10% in the eurozone, according to Moody's. This compares with 75% in the US.
Marlborough's Parker says direct lenders' ability to wrest market share from the banks is country-dependent. These funds have made greater in-roads into the UK and France because both countries are underbanked - there are fewer traditional lenders and the incumbents are relatively poorly capitalised.

Meanwhile, Germany has a highly competitive banking sector and while there is only a handful of Nordic banks, they are well capitalised and therefore willing to hold risky leveraged loans on their books.

Borrower's market
The sheer demand for lending in the mid-market has so far ensured that broader market turbulence has had little to no effect on financing, unlike in the high-yield and syndicated loan markets. However, a number of issues are keeping investors on the back foot. Stock market volatility has made it more challenging for buyers and sellers to meet in the middle and at the end of the fi rst quarter, the consensus is that dealflow in 2016 has so far been muted. Many are also expecting activity to slow in the weeks leading up to the referendum on the UK's EU membership on 23 June.

"I haven't seen any significant tightening of terms, margins and fees going up, or leverage coming down yet because there is plenty of funding out there, but if there's a major incident then we will see," says Lloyds' Sale. "Economically and geopolitically there are a lot of issues in the air."

Mike Dennis, partner in the direct lending group of Ares Management, points out that while the tightening of debt markets in the US is bound to impact large-cap lending in Europe, the former has been more severely affected by the fact that much of the debt capital in the US is structured as publicly listed vehicles. Moreover, the US is more exposed to the woes of oil and gas issuers in light of continued depressed commodity prices. "We have seen spreads widening and documentation tightening on some of the large-cap deals. When this happens, there is a beneficial umbrella effect that filters down into the middle market. However, overall, I wouldn't say there are fundamental differences in structures, pricing and terms in the European middle market yet," says Dennis. "That's not to say that it won't happen. Banks are continuing to lend to protect incumbent relationships, and the direct lending funds are structured as long-locked, closed-end private equity-style structures so, even with volatility, that capital is not going to suddenly leave the system."

Flooded markets
With so much liquidity on tap, some are beginning to question if there is too much lending capacity, particularly in the UK mid-market. Government-led initiatives such as the British Business Bank, which has been backing large asset managers such as M&G Investments and Hermes all the way down to smaller lenders that loan as little as £1m, are creating yet more demand.

Whether or not the mass of funding from non-bank lenders will find a home remains to be seen. But the fact remains that European private equity has never had more financing options on the table. And despite the market volatility felt in recent months, the weight of available capital has, so far at least, ensured that it is still a borrower's market. What is of greater concern is not the cost of debt or where to find it, but the mismatch between available financing and the opportunity to put it to good use.

"The issue is a lack of supply of high-quality new deals compared to the demand that's out there," says Sale. "Bolt-ons to existing platforms and refinancing opportunities can provide deal volume and there are plenty of assets coming onto the market, but people are having to decide whether the new opportunities are very good businesses or just OK businesses. I think we're seeing a lot of less-than-stellar companies that are trying to see if they can get a decent amount of funding while the going is good."

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