There’s a now-classic opening line that Harvard Law School’s deans have been using for decades to address each class of incoming students. It goes something like this: “Look to your left, now look to your right – one of those faces won’t be here by the end of the year.”
Make that four or five years and the same sort of sobering prediction applies to the raft of mezzanine lenders that sprang up between 2000 and 2007. So says Tom Attwood, the long-time chief executive and co-managing director of London-listed Intermediate Capital Group, Europe’s largest provider of mezzanine capital to leveraged buyouts and a global operator from its six locations across Europe, as well as offices in Hong Kong, Sydney and New York.
In Europe alone during the period leading up to 2007, Standard & Poor’s found the number of fund managers that started specialising in the investment of credit rose from three to 116. Roughly 80 percent of those lenders “did not exist five years before the crash, so those fund managers have no experience, have no track record, have got no fire power, haven’t the possibility of raising any new funds”, Attwood asserts. Crucially, he says, such managers also lack experience in dealing with downturns and defaults. “We, on the other hand, have got a 20-year track record generating returns of 20 percent compound.”
Tom Attwood and Christophe Evain: bullish on 2010
During a visit in January to the firm’s London headquarters, that track record – along with reportedly returning more cash to LPs than it was spending pre-credit crisis – is one of the principal reasons Attwood points to when asked about ICG’s ability to survive what were no doubt the most volatile market conditions in its history.
In parallel with the bursting of the credit boom and the subsequent pain experienced across the private equity industry, ICG saw its stock price peak in February 2007 before declining somewhat steadily over the next 24 months. Then, in late January 2009, when ICG warned that deteriorating economic conditions and poorly performing assets would require greater loss provisions, the shares lost a third of their value and continued the downward trend through mid-March 2009. A few months later, the firm booked its first-ever annual loss, owing largely to some £266 million in gross provisions taken on its weakest performing assets.
Although already bearish throughout 2007, ICG continued to make some new investments during that year – albeit on a highly selective basis. Looking back on this period now, in light of what happened in the markets in 2008 and 2009, Attwood admits he wishes the firm had been even more cautious, because unsurprisingly, some of these investments have proved tough to manage.
Weathering the storm
Still, it is difficult to tell from Attwood’s controlled and confident demeanour whether the past three years at ICG have been unusually eventful. Flanked in the firm’s conference room by fellow managing director Christophe Evain, a 15-year ICG veteran, Attwood speaks of the challenges ICG has faced using the same even-keeled tones and candour with which he describes its successes.
He says last year’s loss was the first step on a long road to recovery.
“We like to take provisions early,” Attwood says, stressing that a significant write-down is not the same as a write-off. “We expect over the cycle, as in previous cycles, the portfolio to continue to return good positive numbers over prolonged periods of time.”
Over 20 years, if you'd only ever invested in our realised deals that defaulted, you'd have made 1.2 times your money.
It’s simply not possible to make the types of high-risk investments ICG does and get it right every time, Attwood says. “The absolute key,” he says, lightly pounding his fist on the table for emphasis, “particularly in mezzanine, is to be defensive: make sure you limit the amount of defaults, but most importantly, maximise recovery.” When examining the firm’s results over a prolonged time period, one would see the provisions on day one, so to speak, and the recovery is years four, five or six, he says. “Over 20 years, if you’d only ever invested in our realised deals that defaulted, in the end, you’d have made 1.2 times your money.”
ICG returned to profitability when it reported its results for the six months ended 30 September 2009. “The bulk of the portfolio remains very resilient, 54 percent of our companies were trading level or ahead of last year when we announced results,” says Evain. And the majority of the firm’s top 20 debt assets, which account for almost half of the current portfolio by value, are performing strongly, he adds.
That same set of results notes that ICG’s default rates were well below the market average. From September 2008 to September 2009, ICG’s credit funds, which specialise in primary and secondary senior and junior LBO debt, experienced a 7.1 percent default rate, half the 13.1 percent Standard & Poor’s reported for speculative grade investments. Its mezzanine funds, meanwhile, reported an annual default rate of about 3 percent as of 31 March 2009 – a figure ICG characterises as significantly below that of peers.
Ask a group of private equity professionals what their experience has been with ICG and the phrases “they’re nobody’s fool” and “straight shooters” form a common thread.
“We’ve done a couple of restructurings with them lately and in both cases they’ve been very commercial and tough but we have got stuff done,” says a partner at a European mid-market buyout firm. “They were pretty aggressive in one of them, but no more aggressive than we expected them to be in those circumstances – the way the value break was working on the restructuring was very much in their favour.” At one point during this restructuring, the GP recalls one of his colleagues saying, “’God, they’re really sticking the knife in at the moment’,” but, the source continues, “I don’t think that makes us think any less of them – they’re doing what they’re supposed to do.”
While mezzanine firms, by definition, aren’t usually built to run portfolio companies, ICG has proven itself to be ready and willing to seek controlling equity positions in struggling investee companies if principal shareholders don’t want or are unable to invest further capital during a restructuring process.
The most headline-grabbing example of restructuring prowess has been the ongoing battle for beleaguered UK gaming giant Gala Coral, a victim of wider industry contraction coupled with a heavy debt load. Private equity sponsors Cinven, Permira and Candover in April 2008 injected further equity into the business to assuage leverage levels, and have worked to reduce costs, but the company has continued to struggle and lose value. Though it has not breached covenants, Gala is working with lenders to restructure its roughly £2.5 billion debt load.
The long-running restructuring talks have pitted the mezzanine lenders, led by ICG and Park Square, against private equity suitors and senior lenders to gain control of the company (see Editor’s Letter on p. 1). While talks were ongoing at press time, and there were indications ICG may sell on its position in the company, should the original mezzanine lenders end up in control, Gala Coral would presumably become the largest asset in ICG’s portfolio.
Evain declines to discuss the Gala deal, but he notes: “It’s not surprising that our name is mentioned in quite a number of some high-profile and some lower-profile cases where, quite frankly, if the shareholders don’t do their jobs, then we will”.
Attwood and Evain say it boils down to ensuring the firm recoups every cent it puts out. “We’ve got a team dedicated to making sure we get our money back,” Attwood emphasises.
The team in question has been in place for about a year, when ICG took the unprecedented step of creating a dedicated unit to manage troubled investments. “Typically within our firm, people eat their own cooking: You negotiate a deal, you close a deal, you monitor and exit the deal. If it goes wrong, you have to get it sorted out and that’s been the case for 20 years,” says Evain.
Quite frankly, if the shareholders don't do their jobs, we will.
While ICG has weathered past credit and economic crises, and indeed says the most recent crash has similarities to the early 1990s, its leaders felt the scale of what was beginning to happen in 2007 merited a different approach. Watching companies’ early trading numbers post- Lehman Brothers’ collapse convinced the firm that a more concerted restructuring effort would be needed.
“We took a team of some of our best fund investment guys, a team of about 10 people, people who had restructuring experience, people who had seniority and gravitas,” recalls Evain, “and we said these guys from now on are going to focus on one thing, and one thing only and that’s restructuring.”
The deal’s original cook, to use Evain’s metaphor, still lends a hand in the kitchen and maintains existing relationships, but the restructuring team is brought on for added firepower.
Attwood says most crucial, “is not looking backwards and playing a blame game … not to worry about whether or not it was a bad investment but to get par back. If we put a pound out we’d like a pound back.”
In addition to the begrudging awe with which many GPs regard ICG’s negotiating skills, they also note the depth and breadth of the firm’s franchise.
“They’re well positioned,” says the debt-focused partner of a lower mid-market buyout firm. “They’ve got a broad diversification in just about every way you can look at it – sectorally, geographically, client base, business lines.”
ICG began life as a pure mezzanine finance house in the UK, providing subordinated loans with equity warrants, convertible loans or preference shares. As it expanded its franchise to include European offices, then Asian and American locations, it began to invest in senior leveraged loans.
“Gradually it occurred to us that the skills to analyse leverage are the same in leveraged loans and in mezzanine, although mezzanine is much more hands on, much more about structuring and negotiating, [while] in the senior loan market the skill’s about analysis and being able to buy and sell assets, which is where our team’s got lots of expertise,” Evain says.
ICG has also extended its mezzanine reach to include purchasing minority equity positions alongside company management or private equity sponsors. “There are situations where a mezzanine [financing] really goes toward equity and those might be situations where management owns a business and really needs an equity partner,” says Evain. “It’s out of the scope of most of the buyout shops because they don’t want to do a deal where they aren’t in control. We come from the culture of investing in situations where you don’t have control and you look for ways to have negative control … so it’s natural for us to move into that territory.”
Such moves already seem to be paying off handsomely. The firm’s minority interest in pharmaceutical logistics company Marken, acquired when management purchased control of the business from 3i in 2007, resulted in ICG’s largest-ever balance sheet gain – a profit of £68 million – when the business was sold to Apax Partners in December 2009.
The firm’s latest fund, dubbed the Recovery Fund, will look to participate in the balance sheet restructurings and turnarounds of companies by acquiring such minority equity positions, as well as via the secondary acquisition of senior loans. It raised €544 million as of 30 September 2009, and is expected to hold a final close on roughly €750 million by the end of March.
Attwood: LBO debt opportunities to spike
In addition to stockpiling dry powder in third-party funds, ICG last year refreshed its balance sheet via a €351 million rights issue and the extension of £545 million in existing credit facilities to June 2013. “This has made a substantial difference as it gives us much more freedom of action because we were not at the time – nor was anybody in the market – making realisations at the rate that we were in ‘06 and ‘07, so this gave us fire power to really invest,” says Attwood.
After the limited investment activity of 2008 and 2009 and focus on damage-control and capital preservation, ICG’s dealmakers are expecting 2010 to be marked by fresh deals. The middle market buyout sector is expected to increase its activity levels, Evain says, noting ICG also anticipates a great deal of activity on the “recovery” side. Many of the private equity deals done in the past five years will have debt reaching maturity in the next two to six years and refinancing that debt with equity injections or a mix of debt and mezzanine should yield huge opportunities, he says.
Attwood estimates that in Europe alone, more than €240 billion in buyout-related debt will need to be repaid and refinanced. Expect ICG to be in the middle of it all.