Leveraged credit: buyers in search of cash

In recent months, markets have witnessed the start of a revival in leveraged finance. In the wake of the credit crunch, it was unclear whether this form of higher-risk lending would return, and private equity funds have been limited in the deals they could do because of the lack of debt funding.

But this year the record issuance in high-yield, or junk, bonds has highlighted renewed appetite for riskier assets.

“Leveraged credit is back but – in Europe – so far with much greater reliance on the high-yield bond markets for the bigger financings,” says Anthony Ward, managing partner of the London office of Shearman & Sterling, the law firm.

Globally, junk bond issuance in the year to date has outstripped any other full year, with $253.4bn sold, according to Credit Suisse.

Bonds are playing an increasingly important role in leveraged finance. The big development in European leveraged buy-out financing in the past year has been the rapid growth in the high-yield bond market.

This has been driven by investors hungry for yield in a low-interest-rate environment and the continued reluctance of bank lenders to make leveraged loans, says Mr Ward.

“In many deals over the past 12 months, secured high-yield bond debt has taken the place of traditional secured senior bank debt,” he says.

Ardagh Glass, the Irish bottle maker, used the bond market to finance its acquisition of Impress Co-operative, the tin-can maker, from Doughty Hanson in the UK. The deal, for €1.8bn ($2.4bn), was financed with €1.7bn of junk bonds in September – the largest mergers and acquisitions-related bond offering in Europe in the year to date.

In September, the market saw the first staple financing since the credit crisis when BC Partners, the private equity group, sold Picard Surgelés, the French frozen-food company, to rival Lion Capital.

Also in September, bankers backed a SFr2.55bn ($2.55bn) loan to finance more than two-thirds of CVC Capital Partners’ buy-out of Sunrise, the Swiss mobile phone operator. The financing for this buy-out was the biggest leveraged loan in Europe for two years, according to bankers.

The value of global buy-out deals by private equity groups has surpassed $62.9bn in the three months since the start of July – the highest quarterly total since the second quarter of 2008.

While deal volumes remain well below peaks, the average debt component of buy-outs increased from 30.4 per cent of deal financing in 2009 to 44.3 per cent this year, according to Mergermarket, the research company.

“The theme in leveraged finance is a move away from refinancing activity towards more acquisition finance,” says Mathew Cestar, head of European leveraged finance at Credit Suisse. “Deals that are coming are more conservatively structured, and the majority – 65 per cent – are in defensive sectors such as healthcare or telcos.”

Bankers say financings are becoming more aggressive. Leverage now available in transactions has reached 4.75 times total debt, or even six times, though it still remains below pre-crisis levels.

“The sheer volume of debt available for deals has not been tested yet, but there have been very few pulled deals and there is talk of $10bn leveraged debt packages being achievable,” says Ian Gilday, head of European syndicate and leveraged capital markets at Goldman Sachs.

However, Mr Gilday says current financing structures are attractive to debt providers. The level of equity in transactions has risen to more than 30 per cent of the total enterprise value, while pre-crunch levels fell below 20 per cent. Moreover, for senior secured lenders, which have been part of many debt financings, the leverage loan spreads have been, on average, double their pre-crunch levels.

Mr Ward says he is seeing much more evidence of a return of the bank loan market in the US, which is contributing to increased M&A activity.

“Financing terms in the US are already moving back close to pre-crunch levels, with leverage multiples creeping up and even a few ‘covenant-lite’ deals,” he says. “In Europe, while there is some evidence of the return of the syndicated leveraged loan market, terms remain conservative and pricing is high. It is often the case that the US leads the way in the leveraged buy-out market, and it will be interesting to see if this happens with the European bank lending market.”

Mr Ward adds that one significant development in Europe has been the willingness of vendors to allow purchasers and their banks access to target companies prior to closing a deal, so that they can prepare offering materials to enable the sale of high-yield bonds and/or bank debt immediately after finalising the deal.

“This greatly reduces the period during which arranging or underwriting banks have to hold debt on their balance sheet,” says Mr Ward. “In some deals, high-yield bonds have even closed into escrow after the M&A transaction has signed but before it closed, so that the underwriting banks never had to fund bridge loans.

“This is all about managing the period of market risk in volatile market conditions, and moves the European market much closer to the US model. These developments are good news for M&A activity as they are likely to increase the availability of finance.”

However, a question remains over one of the biggest sources of funding for buy-outs and leveraged credit markets at the height of the credit boom – collateralised loan obligations, which pool leveraged loans and repackage them, funding themselves with highly rated bond issues.

But the market for these structured investments remains muted. “The CLO role will diminish as reinvestment periods come to an end between now and 2014 and repaid cash has to be paid out to senior notes,” says Clayton Perry, chief operating officer at Avoca Capital, the investment manager. “Banks have vastly reduced the amount of capital allocated to leveraged loan holdings, and there have been no new CLOs to leverage the non-bank capital in the market.”

Mr Perry says the market has turned a corner. “If we zero in on 2010, the general picture is one of improvement from the darkest days,” he says. “For the short term, pressure on new issue spread is downwards and potential new deal sizes are larger.”

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