US attendees at Private Equity International' s 2004 European Private Equity Forum in New York in November were left in no doubt as to the current temperature of Europe's leveraged finance environment: speakers with first hand knowledge of what is happening there at the moment described the market as “white hot”.
Delegates discussed the unprecedented series of recent European jumbo LBOs such as VNU, Picard and Saga weighing in with debt multiples not far beneath the eight times mark, and many voiced concern at such aggressive funding.
One keynote speaker blamed the lenders: “Leverage multiples have become ridiculous, the bankers must be smoking something,” he said, adding swiftly that he did not want to see his name against this quote in print.
Others weren't convinced however that the current situation was anything to do with substance abuse amongst the bankers. Far from it: several speakers focused on the well-documented point that, put simply, it's the unprecedented liquidity that is driving the market, liquidity that is pushing down pricing and forcing banks to compete aggressively against many other types of lender – including hedge funds. In such a climate, ever-increasing leverage multiples are among the key devices lenders will use to differentiate themselves.
You could also argue, as one delegate did during a coffee break, that bankers arranging very large debt packages are simply doing their job: “Some of them agree that the current situation is crazy, but they have revenue targets to meet and mouths to feed. Plus they can sell practically all of their books to the syndication market, so the only person left worrying about too much debt being piled on a deal is their internal credit officer – and even they won't worry too much if the amounts they end up holding are small.”
To the equity houses, this wall of cheap capital is obviously good news. With all kinds of lenders trying to elbow into their deals, theirs is a position of strength. “We're spoilt for choice,” commented Oliver Haarmann of KKR's London team while sat on a panel chaired by leveraged finance old hand Stephen Mostyn-Williams.
However, in a rampant market the equity sponsors are having to tread carefully too. For example, Haarmann cautioned that some of the capital being offered was coming from untested sources. When KKR put together the funding for its recent acquisition of ATU in Germany, about a dozen hedge funds called cold, eager to understand the capital structure, Haarmann said.
And there are of course limits to how much debt even the equity houses want to see put on the businesses they are buying. That's not just because an overleveraged company will keel over if cash flows dry up. As Mostyn-Williams' fellow panellist Philippe Costeletos of Texas Pacific Group pointed out, highly levered businesses moving into a rising interest rate environment going forward will likely experience downward pressure on exit multiples. Financial investors will need to find ways to reach their target IRRs despite such potential multiple compression.
From a private equity perspective, this is a critical point. The panellists agreed that in a buyer's debt market clever financial engineering will make a major difference to the performance of their deals. But Haarmann and Costeletos also stressed that financial engineering on its own cannot bring about all the value creation that private equity needs.
So did Guy Hands, chief executive of Terra Firma Capital Partners, who told the audience that in an environment typified by excessive leverage, severe competition and vendors who in recent years had turned from “slow-moving deer” to a species “with sharp teeth and carrying bazookas”, even the upper quartile funds had to work harder to make acceptable returns.
Crucially, Hands added, more leverage and the additional risk that came with it was not the way to get there. “I'd rather stand to make a 20 percent return on an asset with 60 percent of leverage than a 30 percent return with 85 percent leverage.” Instead, he went on, Terra Firma is even more focused on effecting fundamental change to the businesses it owns than it has been in the past – through injecting additional capital throughout the life cycle of an investment, through radical management change, through longer holding periods.
Equity sponsors in other words must roll up their sleeves. The debt market will at some point cool, which will remove some of the current emphasis on optimising the capital structure – but even if the leverage fires burn on, sponsors must not lose sight of the need to improve their businesses through strategic and operational transformation.