PE financing: Lagging leverage

Five banks participated in the early-bird syndication of debt for Bain Capital's A$1.3 billion buyout of accounting software firm MYOB in September. Six months later, only two - domestic banks Macquarie and ANZ - remain fully active players in Australia's leveraged lending market. Natixis has shuttered its Asian operations, Bank of Scotland has closed its leverage desk and Credit Agricole is said to be a shadow of its previous self. It was, as industry participants attest, incredibly good timing by MYOB.

The sharp turnaround in fortunes reflects the climate of macroeconomic uncertainty. One Hong Kong-based lawyer recalls working on a deal last year in which senior debt was issued in place of an expensive tranche of payment in kind (PIK) loans. It reminded him, briefly, of the heady days of 2006-2007. Then the euro-zone crisis hit, prompting many European banks to retreat and US lenders to reconsider their exposure to the leveraged buyout market.

Since the global financial crisis, PE firms in Asia have seen the financing market tighten, with leverage multiples and the debt portion of deals both falling. But the region has traditionally enjoyed comfortable liquidity levels and competitive pricing from banks. Now that the capacity for leveraged loans is dwindling, PE is likely to come under renewed pressure. Financing new deals with senior bank debt is becoming more expensive, which will have a knock-on effect on transaction pricing.

Refinancing deals struck at the peak of the market in 2007, for which the debt is now approaching maturity, may prove difficult if not impossible.

"There are a lot of opportunities private equity firms want to look at but will struggle to get financing for simply because the capacity of the banks won't allow it," says Lyndon Hsu, head of leveraged and acquisition finance for Asia Pacific at HSBC. "And even though banks are stepping up for large tickets to make certain transactions work, they ask for higher fees and higher margins."

Capacity in retreat

Hsu estimates that Australia had the capacity to finance deals of up to $1 billion at the beginning of the year, but these have since fallen to $500-600 million, while Japan, the other leading leveraged market in the region, retains some appetite for lending because the business rates are so low and foreign banks have traditionally played second fiddle to their domestic counterparts.

In Asia ex-Japan, lending capacity is sufficient to back deals of up to $300 million, down from $500-600 million, but the leverage market is less developed and remains patchy, operating very much on a case-by-case basis.

Asia Pacific ex-Japan syndicated loan volume - for all transactions, not just PE - reached a record high of $342 billion from 1,082 deals in 2011, up 27% from $268.5 billion the previous year, according to Thomson Reuters.
Australia also saw significant year-on-year growth, as loan volume jumped 70% to $108.6 billion, while Japan posted a 25% increase to $310 billion. Clearly private equity's capital supply isn't going to be cut off in 2012, but it will be allocated more selectively by larger groups of banks.

For a deal to qualify as top class, lenders must be convinced by the private equity firm's track record, the structure of the transaction, and the target company's performance. Australia's retail sector, for example, is likely to get short shrift unless the company in question has a dominant market position.

"Retail has always been difficult," says Rahul Mathur, co-head of leveraged finance for Asia for GE Capital. "The barriers to entry look good but what does the company really have - a location, a brand? What happens if there is a downturn in consumer sentiment? There is also the fact that the margins are so low, it leaves very little room for error."

A glance at the most successful LBOs from 2011 offers some insight into what might work best this year. Aside from good timing, MYOB's successful financing can be put down to its strong customer base among small- and medium-sized enterprises, well established brand and steady cash flow.

The $375 million high-yield bond that supported Unitas Capital's acquisition of Hyva was possible because creditors in the US were convinced by the company's solid manufacturing business model, European roots (although the majority of revenue comes from Asia) and US dollar revenue streams.

Affinity Equity Partners, meanwhile, cut the number of banks participating in the senior debt tranche of its buyout of Australian meats producer Primo Smallgoods from 15 to 11 because it had too much money. "Primo controls 50% of the deli meats market in Australia so it's seen as a good creditor," says a source close to the deal. "The food industry is also seen as a defensive play."

Pricing points

The consensus is that a deal involving a company with strong operational performance and security for lenders can achieve a debt to EBITDA multiple of 4x. However, different geographies present challenges that can bring the level down sharply. When asked to provide leverage for a China deal, which typically means lending to an offshore holding company that has a legal claim on assets based onshore, a bank might be unwilling to go past 2.5x. The debt portion of the deal, meanwhile, is unlikely to exceed 60%.

It is a very different world from 2007, when debt-to-equity balances reached 75%-25% and leverage multiples routinely touched 7x.

The issue facing private equity firms, whether structuring a new deal or refinancing an existing one, is how to replace the portion of debt that would have been covered by the banks. They are not helped by the fact that PE financing in Asia lacks depth beyond the senior debt tranche.

According to Gavin Raftery, a partner with Baker & McKenzie in Tokyo, mezzanine is making a comeback in Japan as banks refuse to commit the same levels of senior debt. There is no high yield, but he claims to have seen deals within the last year that included some second lien debt plus two levels of mezzanine debt with the more heavily subordinated piece totally unsecured. "The mezzanine players have a real role and they are being brought into structures at a very early stage," Raftery says.

Immature market

These conditions are a long way from being replicated elsewhere in the region. A US or European deal might have slightly lower leverage on the two layers of senior debt than a similar-size transaction in Asia, but it is often backed up by a combination of second lien, senior unsecured and high yield financing. The whole package has a lifespan of 7-9 years.

An Asia ex-Japan transaction, unless it is very large, might barely have two layers of debt capital with a tenure of 5-6 years.

"Until recently there was such a highly liquid senior bank debt market that there wasn't much scope for mezzanine," says John Hartley, head of White & Case's leverage finance practice in Asia. "With bank liquidity drying up, the problem now is that sponsors take the view that, given the pricing mezzanine providers are asking, they might as well put in more equity."

Even Australia, which saw a number of mezzanine players before the global financial crisis and where the likes Babson and ICG are still active, is not as developed as some would like. "There would be a general benefit to deal activity if there were a deeper subordinated debt market in Australia," says Craig Boyce, a managing director at Bain Capital.

As a result of the lack of mezzanine, private equity firms must find other ways to fill out the debt portion of deals that isn't covered by banks. During the bidding for MYOB, KKR and Bain opted to tap retail investors and the selling parties, respectively, for credit.

Both private equity firms were seeking a leverage multiple of around 6x through a combination of senior and mezzanine debt, and the banks were suitably confident in MYOB's business model and competitive position to stretch beyond their 4x comfort zone. According to market sources, KKR managed to secure approximately 4.5x for the senior debt and then arranged bridge financing for a retail note at 1.5x. Bain's offer, which was ultimately successful, saw a multiple of 5x on the senior debt plus a 1.5x PIK vendor note provided by Archer Capital and HarbourVest Partners.

"We effectively had 6.5x leverage, but 1.5x was heavily subordinated," says Boyce. "The vendor note resonated with both parties because of an alignment of interests. For us, it was an attractive form of financing - cheaper than equity financing and very flexible. Archer and HarbourVest believe in MYOB and, as a result of this, they received a higher valuation."

The banks regarded the vendor note as equivalent to equity and so its inclusion took the equity portion of the deal past the 50% threshold, making them more comfortable with the senior debt terms. Yet Bain's upfront equity commitment was in the high 40s.

MYOB might be able to launch a retail note in the future, but this type of financing is difficult to secure. Although a useful option in the absence of institutional demand for debt, a retail note requires the issuer to go through a public offering process similar to an IPO, with the emphasis on disclosure.

HSBC's Hsu, part of the team that helped develop Asia's first retail notes, argues that the product has limited use in Australia and New Zealand and no use whatsoever outside of these countries. "The terms and conditions have developed so that the retail note is now more subordinated debt holder-friendly," he adds. "The debt tends to be A$25-50 million and mezzanine players want 15-20% with Australia creditor laws."

Limited options

With bank capacity falling and in the absence of a workable mezzanine solution, what is a private equity firm to do? The question is most pressing for those seeking to refinance existing deals.

In Australia alone, large chunks of senior debt is due to mature in the next 18 months from deals struck at the peak of the market in 2006-2007.

CVC Partners-backed Nine Entertainment, which has hedge funds biting at its heels over a A$2.6 billion debt pile, is the best known case but not really a model example - the deal is unusually large and so the debt pool is more liquid. While there have been instances of companies going to the wall, with assets snapped up by distressed investors, in other cases private equity firms have found an exit, often through secondary buyouts.

"What we have in the middle are deals that have not been absolutely stellar in terms of performance but have not been pushed into insolvency or major restructuring," says Bryan Paisley, a partner with Baker & McKenzie in Sydney. "Will the banks still be there to support them?"

Industry participants float various options, from limited mezzanine deals to private placement via the equity markets to banks from South Korea and Taiwan - which are trying to build more of a presence in the leverage space - coming in and refinancing the debt.

It is also suggested that the situation is being judged largely on the experiences of several large Australian companies with heavy debt burdens. Deals in the region were never as highly leveraged as the US and Europe and so banks may just opt to refinance rather than restructure, as was the case in 2008.

For now, though, there is a sense that investors across Asia are biding time to see if and when the high yield bond market returns, which might help extricate certain private equity firms from their predicaments.

"People are hoping it's going to reopen in the next few months and there are a number of deals in the pipeline looking to target high yield bonds for a refinancing," says White & Case's Hartley. "If the market doesn't come back, there will be refinancing liquidity issues unless you get domestic banks stepping in."

SIDEBAR: Willing lenders - Who's stepping up?

Not all financial services players are pulling back from leveraged buyouts. According to Rahul Mathur, co-head of leveraged finance for GE Capital Asia, the message he is receiving from Connecticut is to get out there and find private equity firms to finance. "During the financial crisis the market treated GE more like a US bank, given we had some exposure to US short term funding sources," he tells AVCJ. "Now we are positioned more like a strong US corporate, sitting on significant reserves of cash."

Some international banks remain active participants in the market, but there is a distinct domestic flavor to much of what is being done. Although some of these local players have yet to establish an international footprint for leverage, they are now seeking to bridge the gap.

The two major LBO markets of Australia and Japan retain preeminent operators - the big four (National Australia Bank, Commonwealth Bank of Australia, Westpac and Australia and New Zealand Banking Group) and the big three (Mizuho, Mitsubishi and Sumitomo Mitsui), respectively - and in some respects their grip has strengthened.

The Australian lenders have been disciplined in their approach, imposing unofficial caps on the debt to EBITDA ratios and even putting forward proposals to standardize terms for inter-creditor agreements used by mezzanine players. Japan, meanwhile, has always been dominated by domestic operators which are generally comfortable with leveraged deals and offer competitive rates.

Elsewhere in Asia, the competitive landscape is more fluid, and lenders primarily from Taiwan and South Korea are playing a greater role. They are setting up offices in Singapore and Hong Kong and launching operations beyond their domestic borders. "Local banks are acquiring quite a lot of knowledge and skill," says the head of a regional buyout firm. "In many situations, if you get money from domestic banks, the terms are more flexible and it's cheaper."

These lenders are benefiting from low deposit rates in their home markets, which have left them awash with capital and able to take deals at low prices in order to generate more business. While the rise of domestic banks in Asia's leveraged market is clearly a long-term trend, industry participants are cautious as to whether they can counterbalance a weaker Europe. The concern is that these lenders are quick to scale back their exposure in the event of domestic economic difficulty or rising foreign currency financing costs, which curtail liquidity.

"Market disruption increases the cost of funding in US dollar terms," says Lyndon Hsu, head of leveraged and acquisition finance for Asia Pacific at HSBC. "As soon as access to US dollars disappears, these banks disappear from the leveraged finance market."

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Financing
• Australasia
• North Asia
• Southeast Asia
• Financials
• Unitas Capital
• Affinity Equity Partners
• Bain Capital Asia
• Financial Services
• Japan
• Southeast Asia
• Australia
• Leveraged finance
• HSBC