Piling on the debt

Journalists often refer to the summer holiday period of July and August as the ?silly season,? when the search for hard news becomes increasingly desperate. Usually the LBO market at this time is a little less frenetic than normal as well. But this year, recent events in Europe have provided evidence to the contrary. Not only have there been deals aplenty, but also new records were being established with respect to their size. This should give beleaguered LBO debt market participants in search of assets to plump out their balance sheets or to shore up their limping CDO funds some cause for hope.

With so much debt about to be syndicated, the air will soon begin to buzz with debate as invitees focus on that perennial triangle of issues which they compare between deals: How much leverage? What's the pricing? And, the difficult bit, what's the quality of the underlying businesses being funded?

The first question is particularly relevant in the context of this summer, for one trend that has been emerging is that leverage levels appear to be beginning to creep upwards again. Take, for example, the number of recent deals where total debt levels exceeded five times EBITDA – the market's common yardstick for leverage.

Topping this list is PAI's secondary buyout of industrial linen provider Elis at a mooted 6.3x; behind this comes ABN Amro Capital's acquisition of the Channel Island ferry operator Commodore Group at 5.5x; CDR's purchase of Brake Brothers is next on the list at 5.4x, together with, admittedly both somewhat earlier in the year, BC Partners' purchase of Italian cheese and dairy group Galbani from Danone and HSBC Private Equity's buyout of Dignity Caring Funeral Services; and finally the July sale by France Telecom of its transmission towers business Télédiffusion de France at 5.1x. There have also been a host of transactions at between 4.5x and 5x, including, based on what information is currently available, the super heavyweights of Madison Dearborn's take private of Irish-based packaging company Jefferson Smurfit and the KKR-led purchase of Legrand from Schneider Electric, where, collectively, a total of €6.5bn in debt is to be raised.

Where is the comfort zone?
Most arrangers will agree that for the ?right? kind of business, such eye-watering levels of leverage are entirely plausible. Indeed, both Galbani and Dignity proved very successful in the market thanks to the stability and predictability of their respective industry sectors, food and death. Equally positive assessments can be made about companies in defensible niches supplying a unique service or a clear sector leader – as will be argued in respect of Elis, Brake Brothers, Commodore Group and Télédiffusion de France. However, does the business profile of the packaging and electrical components sectors match the leverage levels indicated for Jefferson Smurfit and Legrand? And could it be that the highly competitive nature of their respective sales has pushed pricing up more than a notch too far?

In addressing such questions, it is appropriate to remember the context. Higher leverage levels have, in the past, been a sign of a hot market. However, higher ratios may equally be a result of a low denominator as they are a high numerator. In other words, if EBITDA is low but expected to turn around, couldn't the resulting leverage be high? The answer, quite clearly, is yes, because a ratio only ever represents a single point in time. The more difficult problem with leverage levels has always been the issue of where the comfort zone is in terms of assumed future growth, as any business can withstand what appear to be excruciating amounts of debt if its EBITDA projections resemble the infamous ?hockey stick? profile.

Initial indications suggest that the underwriting community has positively embraced both the Legrand and Jefferson Smurfit deals. Clearly the question as to whether these are over-leveraged transactions will be answered for certain in the near future, but, as investors seek to join the seeming headlong rush towards these and other deals, they will do well to remember that the silly season can affect even the most sober-minded.