Big risks stay off the menu

In early 2002, it seemed for a while as though the European LBO market and with it the leveraged finance providers that feed on it just wouldn't make it out of doldrums. Then, in late spring, activity started to pick up and by September, a flurry of big deals being done had debt providers working flat out, to the extent that sponsors were beginning to wonder whether capacity in the debt markets would suffice. But it didn't last: by late autumn, much of the activity had subsided, and many leveraged financiers sat back down on their hands again.

Slow at the beginning, slow at the end: no wonder 2002 won't be remembered as a bumper year. In the loan market, total issuance dropped nearly 20 per cent, to $75.5bn from $87bn in 2001, according to Thomson Financial. The high yield market took even more of a battering, with issuance plummeting from $6.9bn to $3.3bn. Unsurprisingly, a number of debt institutions were forced to scale back, leaving some of the bigger and more established players to fight over whatever business they could find in the market.

What's a bankable deal?
Quite what this suggests for 2003 isn't immediately obvious. At present, few practitioners are overly excited at the prospect of what lies ahead. ?People won't get paid for taking big risks this year,? says a London-based general partner at a leading private equity house, echoing the views of many.

Risk taking was of course already out of fashion last year. 2002 saw the renaissance of credit fundamentals. From the outset, debt providers were determined only to support businesses of the ?right? quality. Anything that fell outside their sweet spot simply wasn't going to get done, and similar caution is certain to be applied going forward. As Charlie Green, a partner at private equity house Candover, observes: ?The threshold of credit quality to get through the arranging bank's credit committee is high. Once through, there is quite a lot of appetite, particularly in the larger transactions, with no serious constraint on multiples.? But when presented with financing requests that do not fit the bill, lenders are likely to respond with a straight ?no? as opposed to the kind of lukewarm expression of interest that they would usually offer in the past.

The issue here of course is, what exactly is a good quality business from a lender's point of view? According to Euan Hamilton, head of leveraged finance at Royal Bank of Scotland, opinions can differ significantly: ?Banks are more divergent in their views as to what is a quality deal,? he says. ?We're working on a transaction at the moment with another bank where our view is almost diametrically opposed to theirs.? For equity sponsors, therefore, figuring out whether a deal is worth presenting to the debt providers is no easy task.

The increasing focus on credit quality plays a big part in reducing the banks' willingness to do business. And, as more lenders get better at recording and monitoring the overall profile of their loan books, issues such as industry sector concentrations are also moving further up the agenda. For certain transactions, therefore, the universe of potential debt providers can be small, which from the sponsor's perspective increases the delivery risk. Jonathan Feuer, a partner at CVC Capital Partner', explains: ?Some banks say that they don't want to touch this or that sector. This depends upon their own individual circumstances and is totally irrelevant to the quality of the asset.?

High yield hiatus
If sentiment in the loan market is difficult to call, what about high yield? Once again, few marketers are prepared to make any definite predictions. An exception is Eric Capp, a vice president with JP Morgan's high yield capital markets team, who takes a distinctly positive view: ?I think it's going to be a very good year in the high yield markets. If corporate credits begin to access the high yield market, new issuance will exceed last year's levels by 50 per cent.?

?Banks are more divergent in their views as to what is a quality deal?

The outcome will in part depend on whether European market participants can iron some of the problems that began to paralyse the market in the second half of last year. Top of the list is the issue of structural subordination, a problem particularly for bond investors that arises increasingly frequently as a result of bonds that are used to finance transactions being issued by a specially created parent to a target company's operating subsidiaries, as opposed to the operating company itself. Structural subordination is a significant turn-off to high yield investors because in the event of a default, it leaves them second-last in line for repayment, ahead of the equity investors, but behind loan and trade creditors.

Having exercised bond investors for much of the year, structural subordination played no small part in high yield issuance in Europe drying up completely since the limited success of the Jefferson Smurfit transaction in September, the Madison Dearborn-led LBO. Among the transactions that have been delayed as a result are a €600m issue to refinance a mezzanine bridge facility for the acquisition of Legrand by Kohlberg Kravis Roberts and Wendel Investissements. A deal which attracted altogether more attention in the market and the media was the £175m high yield bond for the acquisition by Clayton, Dubilier & Rice of Brake Brothers, the UK-based food distribution business, which was pulled in October. Much has been written about how the transaction could have been handled differently. Suffice to say here that the market felt the deal had been structured too aggressively and that investor appetite had been misread, at a time when demand was distinctly volatile.

Subordination wasn't the only factor prompting investors to shy away from the Brake Brothers bond. Says Eric Capp at JP Morgan, which acted as lead arranger alongside Credit Suisse First Boston: ?This was a new business for the market, no other distribution companies have issued high yield bonds in Europe. It's a low margin business, although activity is highly predictable. The leverage was perceived to be high. The sponsor, although one of the most blue chip firms in the US, was unfamiliar to European investors. And it came in the same week that six other investment grade deals were pulled. It was not really a great surprise that it did not succeed.? The banks are currently working on restructured version of the transaction, to be relaunched later this year.

How to break the subordination deadlock
Demand for non-investment grade debt is likely to remain subdued for as long as buyers and sellers fail to come to an agreement as to how to handle structural subordination. The pain suffered by those active in European high yield investment during the past two years, particularly in the telecoms sector, coupled with the negative perception that this has created in the market, has meant the amount of capital available to the sector has shrunk substantially. Investors, under pressure to restore credibility with their own funding providers, are now focussing on recovery rates following default. This is not without merit. As Capp explains: ?It's not so much the upside that generates high yield investor returns, it's the downside protection which allows portfolios to outperform. Losing 5 to 10 basis points on the downside, and that's all we're talking about with the structural subordination issue, is enough to change the return dynamics of a portfolio relative to others.? Because all high yield investors have had a rough ride recently, calls have been getting louder that structural subordination be reigned in. For the first time in the short history of the European high yield market, a consensus has emerged among investors which has led to an effort of concerted lobbying of debt arrangers and equity sponsors to force a resolution.

Some doubt whether the buyside will stand united for long, pointing to a tendency evidenced in the past to throw off whatever concerns may prevail whenever an appealing new issue comes to market. David Torres of JP Morgan's London high yield sales team cautions: ?The way markets are taking off right now will be the true test of whether they can hold it together or not.?

Other practitioners take an even more cynical view towards the buyside's current calls for change. One senior high yield salesman comments in rather acidic terms: ?The high yield market has always been partly an equity investment. When the equity markets cratered, high yield markets simply reflected their portion of the risks. Investors have been trying to find other reasons why this happened and got hung up on structural subordination, even though this is only to blame for a small portion of their losses. In the US, high yield issues are typically not structurally subordinated, but recovery rates there haven't been much different from those in Europe.?

But that doesn't do much to distract the investors, who are in little doubt as to what they want to see happening. They demand structural improvements in the form of financial guarantees which would effectively put them on a par with mezzanine providers in the repayment hierarchy. However that is a concession that senior lenders in general and the London-based banks in particular, which often also lead the bond issues in leveraged transactions, are unwilling to make. Hawkish bankers view the high yield community as a group of vultures who are simply out to take control of distressed borrowers at their expense. The investors on the other hand are baffled by this accusation. They struggle to understand why buyers of mezzanine are perceived, and indeed treated, so markedly differently from those buying high yield, especially as many such investors are now active across both asset classes.

As recent press coverage has shown, a resolution is proving difficult. But whatever the differences between the feuding parties, most accept that structural changes of some description would help to rebuild investor confidence. And the leading sell side institutions as well as several equity sponsors are keen to reach an agreement, and many are confident that the impasse will be broken.

Amid all the tension, some also feel that the current obsession with structural subordination diverts attention away from other, equally important factors that are limiting high yield's appeal, for instance those that worry the private equity houses. ?There are issues surrounding the sponsor community that also act as a brake on market growth, such as the stability and accessibility of the market and the flexibility of the product,? says Nicholas Coates, head of high yield capital markets at Royal Bank of Scotland. Capp at JP Morgan agrees: ?Some European sponsors are less comfortable with the high yield market because of its volatility, lack of certainty, and reduced flexibility on call structures compared to traditional European mezzanine.?

Thank God for the fallen angels
What should help revitalise investor appetite for high yield debt is that although new issues slowed to a halt towards the end of 2002, the pool of tradable assets in the high yield market actually grew in size, albeit for technical reasons, through the entry of a multitude of so-called fallen angels ? existing investment-grade issuance being relegated to junk status as a result of deteriorating credit quality.

Ironically perhaps, the arrival in sub-investment grade territory is generally being seen as largely positive, mainly because it has resulted in the introduction of larger, better-capitalised public borrowers to high yield investors. It has also brought that magic ingredient required by all fund managers ? diversification. As Michael Guy, a member of the high yield sales team at CSFB, puts it: ?The fallen angels probably serve to give the market real critical mass, endow it with staying power and force a broader mass of investors to look at it and get involved.?

However, caveat emptor is still the appropriate watchword or, as Coates at RBS explains. ?One still has to beware in this market. The companies that we are after are what I call the prodigal sons, i.e. those fallen angels who are likely, in due course, to regain investment-grade status.?

Even if last year's downgrades have given the high yield market a shot in the arm, a full recovery is certain take more time. And the current hiatus, for as long as it lasts, plays into the hands of other forms of funding.

Mezzanine will continue to make strides in any situation where there is a need for intermediate capital. Following the success of the large mezzanine facilities arranged last year for the buyouts of Elis, sold by BC Partners to BNP Paribas, and TDF, acquired by a private equity consortium let by Charterhouse Development Capital, capacity is no longer seen as an issue. Indeed, bets have been placed on how long it will be before the first €500m mezzanine transaction is put together.

Asset-backed financing has also proven its mettle as an effective funding tool, witness the success of NCP, bought by Cinven with the help of RBS, and Travelodge, the Permira buyout that closed late last year which was funded by RBS and CIBC.

It seems safe to predict that 2003 will see similar landmark transactions, all drawing on a suitable mix of bank debt, mezzanine, asset-backed finance and even high yield, even though there are some big humps still in the road. Volatility remains everyone's favourite word, and practitioners will do well to hold their nerve. There is a brittleness to sentiment that could easily be smashed should the balance tilt the wrong way ? a war in Iraq being only the most obvious of a number of threats.

Unsurprisingly, trying to get practitioners to commit to specific forecasts at this stage is like pulling teeth. ?Given the issues in the market at the moment, this will be a far more interesting interview in twelve months time!?, says Euan Hamilton at RBS. Fair point: it will indeed be interesting to see in a year's time as to who will have weathered the storm and remain in the market. We'll be back.