A rock and a hard place

The European leveraged finance market is set to see a level of unprecedented competition in 2008. With the lack of liquidity precluding more than a handful of €1bn-plus buyouts, mid-market deals – the €500m to €1bn range – will be close to the only game in town.

The result will be a mix of regional and international sponsors competing for deals in precisely the range where the ambitions of bulge-bracket banks overlap with traditional lenders. That spells trouble for European commercial banks, which have tended to be dominant in arranging sub-€1bn deals.

“In the €300m to €600m debt range, deals tend to play to commercial banks’ strengths, particularly if they have local leveraged finance representation,” said Paul McKenna, head of leveraged syndicated finance at ING. “In this market, an arranging bank needs people on the ground across Europe who have the ear of the regional sponsors.

“Arrangers typically have to hold a reasonable amount in these deals, which US investment banks tend to be loath to do; and furthermore these deals tend not to produce as attractive ancillary advisory business that attracts the investment banks to the larger deals.”

Many in the market are inclined to agree with that sentiment. But the situation is more complicated according to one investment banker, who said: “Our client base is the top 20 or so sponsors and if they are looking at sub-€1bn deals we will follow them; that does not mean broadening our sponsor coverage as such. We will be working with the same firms on a different set of deals.”

While each of those bigger sponsors may complete just a handful of such deals over the next 12 months, they will be competing against regional and smaller sponsors – many backed by commercial banks – but also against strategic buyers for whom the rising cost of debt is less pressing, something that will make auctions far less sponsor-friendly.

That in turn means banks face competition not only to win mandates, but are also less likely to see those mandates translate into completed deals.

Sources suggest that the economics of €500m to €1bn deals do work for all classes of sponsors – even those with €10bn investment funds. Indeed, this was the typical target range for even the biggest funds until very recently.

A significant change in the flow of deals in 2008 is likely to be in target industries as well as in the capital structures of deals themselves.

“Deal flow will be concentrated in defensive sectors, and come with lower leverage, less senior debt in particular – expect little if any second-lien debt,” said Simon Parry-Wingfield, a MD at Morgan Stanley Global Capital Markets. “Deals will also have multiples and documentation in line with where they were two years ago.”

Even with such features in place, deals are going to be extremely difficult to syndicate as long as liquidity, particularly among CLOs remains constrained.

“Mid-market deals are less affected because they are less reliant on the CLO bid, and indeed investor banks have come back into the market as lenders in the expectation that leverage will fall to more tolerable levels,” said McKenna.

“However, unless you have in place a group of MLAs at the top providing a chunk of final-take liquidity, even €400m to €500m of debt would still need an institutional investor bid to get the placement done comfortably.”

An investment banker took up the point, saying: “In principle, the bank bid is there to support these deals, but it is tightly constrained too. Investor banks have issues themselves around SIVs, CDOs and Basel II, which makes getting a deal through a credit committee very difficult.”

Therefore, McKenna believes, syndication will be tricky and participation tickets small. “That means hit rates need to increase and to achieve that, deals have to be structured to bring in the marginal, most cautious investors,” he said.

As a result, underwriters now face increased competition to win mandates on a smaller universe of deals but have to maintain the highest possible credit standards to sell down the debt.

McKenna said: “Deals where the borrower was just covering interest repayments are no longer acceptable. The debt to capital measure, or equity cushion, while still relevant, is no longer the only lending criterion that matters.

“Most bank investors for most businesses would now like to see structures where senior debt will be repaid in full within the senior debt tenor, usually nine years, based on an assumption of no increase in Ebitda, and most certainly on a low growth case scenario. I doubt if that criterion was fulfilled on many deals in the first six months of 2007.”

There are some bright spots in the doom and gloom, though.

“Sponsors are aware of the issues affecting the debt market, and are more interested in getting the deals they want done than in playing arrangers against each other,” said a banker. “That is not to say they won’t push for the best terms, but they know arrangers will walk rather than underwrite the wrong deal.”

And arrangers selling down post-crunch deals in the primary markets might find buyers despite the value to be had in secondary.

“Secondary markets remain weak, but new primary issuance will be better quality and more defensive, making it attractive to bank investors for whom discounting is unimportant and also to any new CLO trying to ramp up in a context of very little new supply,” said Parry-Wingfield.

Nonetheless, such sentiments remain the slimmest silver lining on very dark clouds. Concern continues to grow that the darkening macroeconomic climate is undermining and devaluing existing portfolios of loans, making the business of selling any credit extremely difficult.

The challenge for arrangers is that they must compete hard to remain active while offering sponsors as few concessions as they possibly can.