Friday Letter: Here come the institutions

European leveraged finance professionals would surely agree - with a few exceptions - that the environment in which they operate has become decidedly more eclectic - as well as diverse - over the last year or two. This is reflected in both the sources and amounts of capital now available to fund transactions. That much appears self-evident. There is, however, scope for more divergent views when consideration turns to the ways in which such increasing diversity is affecting traditional relationship dynamics in the industry.   

There are many arguments in support of the view that, as LBO transactions have become larger, so the debt financing structures supporting those deals have grown concomitantly in both size and sophistication. The broader spectrum of risk/return in structures is evident, for example, in the burgeoning second lien layer that has swiftly and aggressively muscled into the space between senior debt and mezzanine. 

The rise in significance of these products in the capital structure unsurprisingly has brought a variety of new participants to the leveraged party. The phenomenon is most clearly visible, in a European context, in the rise and rise of those who may most usefully be dubbed “the institutions”. Having accounted for an almost inconsequentially small proportion of the leveraged market just a few years back, the likes of hedge funds and CDO funds are now accounting for around half the total market volume of leveraged loans, and are beginning to push toward the overwhelming majority share they already enjoy in the US.

But this is where things become a little problematic for those who believe that what matters in leveraged finance is not so much what you have but who you know. Bankers will tell you that syndicates operate most efficiently – through good times and, perhaps more importantly, through lean times – when the participants all know and trust each other, perhaps having worked together on similar deals before. Such a smooth passage is much harder, say cynics, when you cast these newer institutions into the mix. They are, it is frequently claimed, clearly less relationship-oriented than the banks. As one managing partner at a large buyout group hissed to PEO a while back: “I don’t want any 23 year old in my capital structure.”

It should be stressed that it would be misleading to paint these institutions as an homogenous entity. Some espouse a rough and ready – and at times joltingly short term – trading mentality, while others are established and respected fund managers focused on long-term outcomes (consider, for example, the migration to Europe of august US-based institutions such as Primerica and Black Rock). In this context, it shouldn’t take too much in the way of due diligence to reveal all you need to know about an institution’s past experiences and future attitudes.

Nonetheless, there should be no complacency on this issue. In the event of portfolio companies experiencing problems down the line, can you be absolutely sure that everyone will end up singing from the same hymn sheet? One glance over the other side of the Atlantic confirms that this is not always the case. The latest issue of Investment Dealers Digest related details of the bankruptcy proceedings at power company Calpine thus:  

“As the hearings progressed, it became clear that the second lien lenders, in particular the hedge fund reps, were determined to play hardball…they seemed interested in maximising their recoveries, regardless of the implications on Calpine’s long-term viability. This rubbed Calpine’s first lien debt holders, mostly banks, the wrong way, and got the bankruptcy hearings off to a raucous start. The battle rages on today.”

While acquisition financiers may insist that the relationship banking ethos is as ingrained as ever, there is also an acknowledgement that in today’s climate, their focus primarily is on distribution rather than credit risk (given the diminishing imperative – or in the case of multi-billion dollar deals, the feasibility – for them to hold large positions on their own balance sheets). Unless guided otherwise by the equity house, the lead bank will likely view size of cheque as a rather more important quality in any syndicatee than a commitment to be a good and faithful partner.

This would seem a worrying trend for equity providers  – yet the degree to which they remain masters of their own destiny should not be underestimated. As one LBO luminary pointed out to PEO today, if you are pushing the leverage on a deal so far that you end up feeling paranoid about the make-up of the debt syndicate, perhaps you should do a double-take and consider whether in fact you are looking at an over-leveraged scenario. It could be reasonably argued that ultimately you get the syndicate you deserve.

PS: You are receiving the Friday Letter a day early on account of the widespread holiday tomorrow. Happy holidays.