Primary struggles to its feet

With the anniversary of the initial impact of the credit crunch approaching, the financing sector has found no quick fix to the core issue in the market – liquidity constraint. Recent activity shows arrangers are successfully structuring and pricing debt, overhang deals are performing well and selling, but the potential for further slippage remains.

The impact of the credit crunch on the European leveraged finance market has been devastating. According to Thomson Reuters, in the five months to the end of May 2007, buyouts worth US$243bn were announced. The tally for the same period in 2008 is just US$30bn, the proceeds of some 60 deals.

Eric Capp, global head of leveraged capital markets at RBS, insists that the market is open, saying: “There is an incorrect notion that the market is closed. The market is open but in a different way than it was a year ago. Liquidity is substantially reduced compared with 2006 and 2007. There are fewer market participants, including commercial banks, mezzanine funds, a few hedge funds and a very small amount of CLO liquidity.”

Ian Gilday, managing director in Goldman Sachs’s financing group agrees, adding: “The challenge, as always, is finding the market level, both in structure and price, and composition.”

Meeting that challenge has been tough and while banks insist that the market is open, sponsors are struggling to find backers.

“Banks are far more selective in what they are prepared to underwrite,” said Neil Thomson of Apax Partners.

Both banks and sponsors suggest that the number of banks with actual underwriting appetite has fallen by more than two-thirds since last year, from about 30 before the credit crunch to between six and 10 today. For those that remain active, underwriting appetite is increasingly dependent on sector and credit, with caution the watch word.

Proceed with care

Even where a bank will underwrite a conservative debt package, they are doing so with an eye to uncertainty, ensuring that structures have the flexibility to be launched in uncertain markets.

Eric Capp notes that this is reflected in the degree of flex available in new era loans, saying: “Flex has changed significantly from 2006/07. There can be up to 100bp of margin flex – depending on the tranche, plus structural flex, call protection and OID flexibility.”

Uncertainty remains a given, but with a range of post-crunch deals now completed there is more visibility on what is needed to clear the market.

Ian Gilday cites the buyout of UK oil services group Abbot as key, saying: “Every deal tells a story of where the market is. Abbot was the first big deal, with over US$2bn in debt committed post-credit crunch and placed successfully in Europe. In that regard it showed the way forward – since that initial commitment and syndication, however, there have been mixed results in what I would characterise as the large deal market.”

The US$2.16bn of debt that backed First Reserve‘s acquisition of Abbot is the only recent deal to secure a structural flex after a successful syndication. The debt ticked many of the boxes that investors are keen to see. As well as a defensive sector and a sector-dedicated sponsor, the deal was well equitised and pro forma leverage was 3.73x through the senior and 5.65x total.

Geography matters too, especially in the Nordic region, which recently saw Commerzbank, BNP Paribas and RBS’s syndication of the €715m debt package backing EQT‘s secondary buyout of German power plant builder SAG benefit from its regional ties.

“There is more transparency in the market,” adds RBS’s Capp. “So while the market has traded off since last November/December, it is easier to be more confident about where liquidity and pricing are.”

However, while there is a return to conservatism there has not been a reversion to standard LBO loan structures. Most loans feature senior and mezzanine tranches but several all-senior clubs have cleared the market and there is liquidity to match a range of financing options.

Capp even sees high-yield notes as a viable financing alternative, though that market has been shut since July. “The liquidity is there to support a range of different structures, from traditional A, B, C over mezz; to A, B over high-yield or even all bond deals,” he said. “For high-yield the issue has been a lack of supply rather than a lack of liquidity although jumbo deals would be difficult.”

Despite the general scarcity of liquidity, margins have seen only modest rises over the past year, relative to the depth of the credit crisis. One institutional investor cited regional commercial banks as the “culprits”, for their failure to push arrangers and sponsors on margin.

“I’m struggling to see why regional banks in particular are accepting what they are in Europe, especially versus the US,” said the investor. Moreover, the US is ahead in terms of tightening up covenants.

“We are still seeing 25% headroom in Europe,” said the investor. “What we should be seeing are robust recession-proof structures, with tight covenants, tight controls on use of cash, institutional pieces priced at 400bp over and offered with an OID rather than call protection.”

Indeed, bankers note that some banks are still accepting prices that ignore their own cost of capital, arguing that without closing the relative value disparity between primary and secondary markets, arrangers will struggle to attract liquidity and sponsors will not be able to access large-scale financings.

Where prices have been pushed is in the sell-down of last year’s overhang. Here, banks were desperate to remove the exposure from their balance sheets and with fast money, notably from private equity-backed vehicles, there was never likely to be much attention paid to the relatively puny returns on offer in primary.

“Alliance Boots is doing fine and senior debt sold at 91. If that credit had gone wrong in the meantime, banks would have slit each others’ throats to get it off the books,” according to one investor.

As such, although the market is slowly recovering, confidence is still tenuous and bankers and investors both agree that any creep up in defaults could easily derail the entire process.