As if the private equity sector needed more evidence of its record levels of business, along came the possible take-over bid for UK retailer Sainsbury. Private equity giants Kohlberg Kravis Roberts (KKR), Blackstone and CVC were soon looking at a company valued at £8.7bn (€13.2bn), one billion more than it had been before deal news leaked and speculation began that it could become Europe’s largest-ever private equity buy-out.
While these sorts of details may have come as a bolt from the blue to British retail investors, institutional players have become both familiar with the names, the sums of money involved and the more intriguing story of the recent success of private equity deals.
Leveraged buy-outs (LBOs) by private equity firms are not only raising cash for the takeovers from institutional players but bringing a broader range of securitised debt to the dealing tables. The secondary market has also boomed.
Higher debt levels
At the same time observers are concerned with the higher and higher levels of debt servicing bought-out corporations are facing and the growing league table of debt structures.
The three players in the Sainsbury question are among the largest private equity firms in the business holding assets worth around $400bn (€310bn). KKR organised the infamous buyout of RJR Nabisco in 1988 for $29bn which held the record for the largest private equity deal for nearly 15 years, only recently broken.
“While it could be argued that the private equity business has been in a bull market for at least the last decade, with a pause during the financial hiccup of the millennium, the growth in liquidity and deal size over the past two has been staggering,” says David Morris, UK-based managing director of Iceland’s Landsbankia Commercial Finance.
According to Bloomberg data the value of deals in 2006 were worth almost $700bn. Private equity firms raised $400bn worldwide last year, 29 per cent more than in 2005 with both years being records in terms of cash raised and the numbers of deals, announced according to Private Equity Intelligence’s 2007 Global Fundraising Review.
“The big theme at the moment is the size of the buy-out for the funds being raised,” observes Tom Lamb, co-head of Barclays Private Equity. “Five years ago raising $5bn for a deal was large fund, now it has to be over $15bn to be considered large.”
These so-called mega-buyout funds, those over $2.5bn in size, utilised about 60 per cent of all new capital raised in the US (65 per cent in Europe).
Of course not all markets are the same in deal structure, dynamics or size and US-focused funds continue to dominate, taking 63 per cent of global private equity business with 27 per cent coming from Europe.
Arjan van Rijn, head of syndication and sales for leveraged finance with ABN Amro Asset Management agrees there is a differing pace between certain markets: “Historically, there were many differences between the two markets [US and Europe], but as a result of the influx of institutional liquidity in Europe, the differences are diminishing rapidly,” he says.
He estimates that between 60 and 70 per cent of the liquidity in the European market is coming from institutional players, against traditional levels of 20 per cent. According to buyout specialist Candover European private equity deals reached a total value of €178bn in 2006, up 41 per cent on 2005.
In so far as Europe’s institutional investors have followed their American cousins to private equity doorsteps, their deal size is generally much smaller although transactions with a value of more than €1bn contributed to nearly 70 per cent of the market in final quarter of 2006 and the largest buyout was the €8.3bn takeover of Philips Semiconductors.
Bucking the trend
However, in spite of the fanfare surrounding a possible Sainsbury deal, the UK has taken a step out of line with everyone else. While deal sizes, such as United Biscuits being bought for £1.6bn last year, remain impressive, there is a certain amount of cynicism in the UK markets.
“While there have always been the concern that private equity funds are rapacious investors, they look at the longer term generally wanting to run a good business,” says Mr Morris. “Listed markets don’t always favour a company and give it time to improve but there is a recognition that it is a cyclical business and the levels of debt do create some concern.”
Barclays’ Mr lamb warns: “The UK remains one of the more sophisticated private equity/leveraged buy-out markets in Europe, but as the US trend of taking companies from public to private increases, this activity in the UK has declined,” warns Mr Lamb. As he points out, there has been a lot of talk about deals but far less activity. “There’s a feeling that if a private equity company makes a bid for a listed firm, then the listed business is too cheap so reject the bid,” he adds.
Nevertheless, the business is awash with cash. Global-wide low interest rates have certainly helped and pushed institutions to participate.
 | “In 2003 about 70 per cent of syndicated deals backing leveraged buyouts were placed with banks. Today 70 per cent plus is placed non-bank investors,” estimates John Sinik, co-head of European leveraged finance at UBS. |
Sinik: default rates at historic lows
In part this huge change in financing, in Europe in particular, is as an indirect result of the 2000 financial crisis. As pensions and insurers sought to make up for huge equity losses and seek alternative investments to diversify risk, more cash was dumped in the pot. As they invested in hedge funds, hedge funds sought value from private equity debt issues.
“Relative to investment grade products, debt investors are attracted to the yield uplift offered by leveraged credits. Over the past four to five years, the default rates on leveraged deals have been at historic lows,” says Mr Sinik.
These leveraged loans, which often are credits priced 125 basis points or more over the interbank offered rate, reflect a higher risk posed by the borrower. As the business has developed, so too has the sophistication of the private equity companies in stripping various elements of the loans into collaterallised debt obligations. These range from senior debt issues down into the bowels of junior mezzanine debt.
“The mezzanine debt market has grown dramatically and hedge funds, in particular, are active in taking paper like that,” points out Mr van Rijn at ABN Amro. While this sort of paper is much riskier in its subordination, its returns can be higher and is often bought to reflect a fund’s broader strategy.
For all the parties involved, the fact that defaults are at a 20-year low is reassuring but players believe its not all good news. “Clearly the levels of leveraging are increasing and are at an unprecedented high and everyone is realising that early warning signals of trouble are not what they were,” warns Mr van Rijn.
As banks sought more and more business, terms of debt deals have been made more attractive. “The covenant-like structures employed by banks to ensure repayments have been eased and eased,” explains Mr Lamb. These covenants would demand more money from private equity funds should the underlying company's cashflow fall beneath a certain level, for example.
“Often the terms of loan now don’t expect any repayments for up to eight years,” says Mr van Rijn.
“Ten years ago a medium term loan would have meant repayments on day one over seven years, today you might not pay for the first two years – capital repayments are being pushed further back meaning they can borrow more,” agrees Mr Lamb at Barclays.
He agrees that the boundaries are being pushed. “The thing is it's only when the tide goes out you find out who isn't wearing trunks,” he adds.
In the late-1990s several firms were caught with their pants down. “Then debt investors were prepared to lend to alternative telecom carriers that were producing negative cashflow. Today we’re looking at proven business models with strong track records of cashflow generation," says Mr Sinik. Even so he has concerns.
“We continue to believe that we’re operating in a semi-cyclical business but we don’t know when a downturn will come whether it’ll be a hard landing or a soft bump and what will spark it,” observes Mr Sinik.
As for future growth private equity firms are increasingly having to cast their net wider to find suitable prospects. Just as they’ve moved up the value chain by buying huge firms and not just companies in a distressed state, they’re looking at Eastern Europe and Asia which raised 5 per cent more than during 2005.
SECONDARY MARKET FUELLING EUROPEAN GROWTH
Leveraged buy-outs by private equity funds have stimulated the growth of a secondary market in the trading of leveraged loans. In part the growth reflects an increased appetite for risk and, for some, the higher yields in the broader investment world.
“The growth of the secondary trading market for syndicated debt is helping to fuel the growth of European leveraged finance. This is now more closely mirroring the US market, where a strong secondary market has been a feature for some time," says John Sinik, co-head of European leveraged finance at UBS.
Collating accurate figures for the private equity secondary market remains difficult with a certain lack of transparency. “Today the instruments are so widely disbursed and often you don’t who’s holding it,” observes Tom Lamb, co-head of Barclays Private Equity.
It includes the resale, and in certain circumstances, repackaging of debt held by primary deal financiers such as institutional investors, lending banks, private equity firms themselves and hedge funds.
In 2005 it is estimated that about a third (in value) of private equity deals were in the secondary market according to the Centre for Management Buy-Out Research.
The upturn is partly because private equity companies have become far more imaginative in their debt structures. Increasingly, they have taken the underlying collateral pool’s single risk-profile and spun it out into multiple risk-return debt products. The higher rated securities with a lower return but better risk profile are more appealing to certain institutional investors like pension funds. Other more esoteric structures, usually with much higher yields but far more junior, can appeal to hedge funds either to simply boost returns or reflect a strategic position.
“We’re seeing combining and packaging of collateralised debt obligations (CDOs) to produce various structures and we're seeing banks selling on exposures to institutional investors as well,” adds Mr Sinik.
“CDOs are proving to be dynamic in helping the secondary market,” agrees Arjan van Rijn, director of leveraged finance with ABN Amro Asset Management.
Nevertheless the complex structures require a certain level of understanding of the both the underlying instrument and the underlying asset base and cash flow to fully asses risk and return. “The marketplace is gobbling up whatever debt is being offered but I do have concerns since I know in some cases participating buyers aren't even reading the documentation,” warns Mr Lamb.
