Leveraged finance: Coming to America?

Bradken is feeling the full force of the commodities downturn. The listed Australian company relies on the resources sector for more than 90% of its revenues, with one quarter tied to iron ore mining and processing activities. Having seen iron ore prices fall by half over the last 12 months, miners are scaling back exploration. This means less spending on crawler systems and other excavation equipment.

Last December, with Bradken's share price in the doldrums and its earnings showing little promise, the would-be buyers made their move.

Pacific Equity Partners (PEP) and Bain Capital first submitted a proposal in August that did not result in an offer. This time their A$872 million ($731 million) bid prompted Bradken to say it would open its books to all potential suitors. But it came to nothing. Unrest in the commodity and financing markets made it impossible to secure debt for the deal on acceptable terms.

Bradken is a classic cyclical business that would benefit from the borrower-friendly term loan B or high-yield bond financing often found in US leveraged buyouts. Unencumbered by maintenance covenants that could allow creditors to seize control in the event of a breach or obligations to make regular debt repayments, a PE buyer could focus on restructuring the company and riding out the cycle.

If there is a deal to be done on Bradken - another offer was rejected earlier in April - it would likely be financed by Australian banks as US investors shy away from mining services. Several banking sources argue that Bradken is not well understood outside of Australia and local lenders would be fairer in assessing its credit. But they would also insist on standard covenants and amortization; while not necessarily a deal breaker, sponsors used to US terms might rue the reduction in operational flexibility.

"The US market is an institutional market so there is a natural momentum to the money flows. Certain industries come in and out of favor," says Shannon Wolfers, a director at PEP, who declines to comment on Bradken or mining services specifically. "There are a lot of energy companies in the US that were funded through term loan B and when energy pricing started to fall the market effectively shut. The Australian market, being a bank market, is more stable."

This shift in sentiment is reflected in other deals in the space. While The Blackstone Group's acquisition of Orica Chemicals was financed out of the US, the loan had to be flexed to improve pricing for investors, as first reported by Debtwire. There has also been uncertainty over the debt structure being used to support Apollo Global Management's investment in Leighton Holdings' maintenance services business.

Declining demand

It is symptomatic of an environment in which US demand for high-yield exposure has weakened, making it harder for sponsors to get acquisition or refinancing packages for Asia-based companies on terms and at prices they can accept. With regional banks willing to lend on a more borrower-friendly basis than before, the question facing PE firms is how much of a premium would you pay for covenant lite?

"On the demand side it is a very fickle and volatile market" says Rupert Manduke-Curtis, head of origination for non-Japan Asia at Mizuho Corporate Bank. "Whilst CLO [collateralized loan obligation] issuance in 2014 was the best year on record, estimated net demand for assets across CLOs and loan funds turned negative in December 2014 and the second lien market has all but disappeared in the first quarter of 2015."

He adds that, in terms of M&A, people are waiting to see when interest rates rise because that might trigger a technical outflow of money from the equity market, with a corresponding downwards adjustment in valuations.

Although CLO issuance rose year-on-year in the first three months of 2015, the total of $23.9 billion represents the weakest quarter over the last 12 months. Meanwhile, mutual funds have seen net outflows in each of the last four quarters totalling $37 billion. The volume of corporate leveraged buyouts in the US stood at $126 billion for the most recent quarter. In the first quarter of 2014 it reached $293 billion, much of it recapitalizations.

In addition to cyclical businesses, US term loan B and high-yield bonds are suited to situations in which cash is being directed at expansion, for example if a retailer wants to open many new stores. A "bullet" repayment on maturity or 1% amortization is kinder to the balance sheet. Covenants that are tested on an incurrence basis - i.e. they are triggered by a particular event - as opposed to maintenance tests carried out at regular intervals also offer greater freedom.

However, the reality is that few Asia-based companies are accepted by the US markets. Term loan B has featured in a spate of Australian deals - most of them refinancing or recapitalization events - since 2013 and also crept into a small number of transactions elsewhere in the region. Generally speaking, there must be a debt portion of at least $300 million for a company with no less than $100 million in EBITDA.

Good for Goodpack

KKR's S$1.4 billion ($1.1 billion) privatization of Singapore-listed intermediate bulk container manufacturer Goodpack last year was the first time a PE firm used a term loan B to support an acquisition in Asia. This was because the deal met the criteria US investors might set out: a recognizable sponsor; an established, developed market client base; substantial US dollar revenues; and a jurisdiction that is seen as transparent, strong on anti-corruption, and with creditor-friendly legal frameworks.

"If you look at recent Asia-based issuers' attempts to tap US capital markets, the successful issuers all had trading counterparties that are well-known multinational corporates with a large US and/or global presence," says Lyndon Hsu, head of leveraged and acquisition finance for Asia Pacific at HSBC. "The US capital markets can get comfortable with that kind of business."

Also in 2014, Blackstone financed its $625 million privatization of Pactera Technology International through a $275 million high-yield bond, only the second time such a structure had been used to support a leveraged buyout in Asia. It is instructive to compare the deal to a somewhat similar transaction where US financing was considered but not pursued, the Baring Private Equity Asia-led take-private of Giant Interactive.

Both companies are Chinese, presenting a legal and enforcement risk, but they were also US-listed, which means there was a degree of transparency to their business models. However, while Pactera provides IT outsourcing services to multinationals, Giant's revenues are driven by online gamers within China. The former is easy for US investors to understand; the latter less so.

Timing was another factor that weighed in Goodpack's favor. "They hit the market when there were still massive inflows and the supply-demand imbalance was in favor of the borrower rather than the lender," says Mizuho's Manduke-Curtis. "That has changed now. People with cash to deploy are calling the shots even in a relatively asset starved market."

The $520 million first lien and $200 million second lien term loans for Goodpack had margins of 375 and 700 basis points over LIBOR. The entire package, which was fully underwritten, had a leverage multiple of approximately 6x - high for Asia but KKR acquired the company at a valuation of 11-12x EBITDA. A source familiar with the deal says it would still get done in the US today, despite weakening demand, although the overall margin might be 50-75 basis points wider than in August 2014 when the financing closed.

Fast forward to the end of 2014 and a lower quality business seeking a more modest amount of leverage would have struggled. "If you went with 4.5x leverage in the US it wouldn't be underwritten and you would get a maximum 3x first lien at 500 basis points. The rest would need to be second lien, priced 350 basis points wider than the first lien," the source explains. "In Asia banks will still underwrite deals at 4x and 400-450 basis points for a single tranche structure, but you have covenants and amortization."

Another KKR investee, Singapore-headquartered disk drive manufacturer MMI, found itself in a similar position. Having completed a partial refinancing through a US high-yield bond in 2012, MMI sought a term loan B plus second lien - Debtwire put the total package at $580 million, including a dividend recap, with leverage of 4.6-4.7x - but was caught by a widening in the margins. The deal needed to get done as soon as possible so the company went for an Asia-based bank package.

Shifts in Australia

Timing was also a consideration for PEP in refinancing New Zealand-based biscuits and snacks producer Griffin's Foods through the Australian banks rather than the US market. The PE firm ran a dual-track process and found that the amount of debt on offer was roughly the same but it was cheaper to do the deal locally.

A key factor was that Griffin's, a portfolio company since 2006, would likely soon be exited; indeed, the business was sold in July of last year. PEP could take some money off the table immediately or simply wait for the full exit, so picking the lowest-cost option was important. At the same time, covenants were less of a concern because a lot of debt had already been paid down and Griffin's was not overleveraged.

Over an approximately 18-month period from May 2013, PEP refinanced the debt held by eight of 10 portfolio companies. Three of these were done in the US term loan B market, including the first for cinema chain Hoyts Group. PEP went to the US because Australian banks were uncomfortable with dividend recaps for PE firms.

"After the global financial crisis, local banks had a real aversion to doing leveraged recaps," says Bryan Paisley, a partner at Baker & McKenzie. "It might be a business they knew well because they had been banking it for a number of years, so it's not as tricky as doing a new deal, but there was a degree of ideological resistance to the idea that the equity would get a return while the banks were increasing their exposure."

At the same time, quantitative easing (QE) in the US prompted a surge of money into the debt capital markets and the demand-supply imbalance meant there was less resistance on terms. According to Shannon Wolfers, a director at PEP, first lien debt was available out of the US at a margin of around 300 basis points compared to 400 basis points in Australia.

"Once you put currency swap costs on top of that it came back to being line ball from an interest cost perspective. Whenever we had looked at in the past the US was more expensive because of the costs of hedging the currency and the relevant spreads," Wolfers says. "That changed for a period, for certain companies, with QE in the US."

This disconnect could only be sustained for so long. While the US market has weakened, Australian banks responded to the competitive pressure by doing dividend recaps and offering better terms. Opinion is divided as to how much ground has really been given. On dividend recaps, Baker & McKenzie's Paisley observes that local banks are willing to accommodate a private equity undertaking but only for specific credits.

One Australian banker estimates that margins have narrowed by 25 basis points in the last six months, while mezzanine tranches - typically holdco PIK notes that sit outside the operating businesses against which senior debt is provided - are increasingly popular, allowing up to another turn of leverage. The counterpoint is that Australian banks are relatively conservative, largely sticking to 4-4.5x for senior debt for private equity buyouts and mezzanine financing is neither available in large quantum nor cheap.

David Brown, managing director at PEP, adds that the amount of leverage and nature of the covenants may vary between the US and Australian markets over time. Even so, the vast majority of the firm's deals have involved the Australian bank market and so high levels of leverage and covenant lite have never really been part of the business model.

Baker & McKenzie's Paisley notes that a number of global PE sponsors find local banks difficult to deal with and go to the US markets whenever possible. "I can see why a US sponsor, used to the terms and conditions in the US term loan B market, would be underwhelmed with they would get in a syndicated loan deal in the local market," he says.

Local lenders

Those that are willing to engage find the most significant change is local lenders' willingness to provide larger amounts of debt than before. They are driven by ample capacity. It helps that Australia has seen a large number of exits over the past 18 months, bringing down the net size of the banks' leveraged loan books. At the same time, just like banks elsewhere in Asia, they want to compensate for deals lost to the US markets.

"The bank loan market is very liquid and when there exists a meaningful supply-side disequilibrium, banks become relatively more aggressive on lending terms, and therefore more effective in competing with the US markets, and importantly they reduce pricing," says Hsu of HSBC. "Presently, bank loan pricing is relatively cheap compared to where it and US markets pricing levels were 12-24 months ago."

In certain markets, there is enough local currency liquidity that deals are routinely covered by domestic banks. In Japan financing is available at leverage multiples of 7x and margins of 200 basis points; investors are happy to live with covenants at such pricing levels. According to David Irvine, a partner at Linklaters, Permira refinanced Arysta LifeScience out of the US because in this case covenant lite was deemed essential: the company has assets worldwide and is subject to currency fluctuations that could theoretically cause a drop in profitability and a breach of maintenance covenants.

Elsewhere, TPG Capital sought to refinance Chinese packaging company HCP Holdings through the US markets but couldn't get it through. Debt was instead provided by banks in Taiwan, where the business is well known.

Taiwan lenders are increasingly active in deals throughout the region, offering highly competitive pricing and usually as part of a syndicate. They are said to have featured prominently in refinancing packages for MMI and for Hong Kong Broadband ahead of its IPO. There is also a willingness to cover smaller deals in their entirety, as was the case with a $120 million facility for a take-private of Chinese hotel chain 7Days Group led by The Carlyle Group in 2013.

The capacity of Taiwan banks is limited and they are unlikely to step up for more than $200 million of a $1 billion deal. However, HSBC's Hsu believes there is sufficient liquidity among the Asian and international banks to accommodate a $2 billion buyout for an attractive company. "If it's the right name, the right sponsor and the right country then the volume will almost certainly be there. Once you start un-ticking those boxes liquidity decreases," he says.

Asked about the prospects for the volatile US term loan B and high-yield bond markets, industry participants unsurprisingly offer somewhat differing views. An executive with a global buyout firm who asked not to be named claims the US market is reopening for Asia-based companies and building up to another strong year, while there is also appetite for high-yield products in Europe.

Manduke-Curtis of Mizuho is more circumspect, suggesting there may be a feeding frenzy in CLO issuance ahead of regulatory changes that would hold back managers or arrangers. At present they contribute only a small portion of the fund's equity stake, which typically accounts for 10% of total value. From 2016 they would have to hold 5% of the entire CLO through maturity in equity or debt.

"There will likely be significant consolidation amongst fund managers and a reduction in total CLO issuance," he says. "And before that, once interest rate rises come through - whether it is June or September - a lot of money will likely move back into the bond market."

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

• Topics
• Financing
• Buyouts
• Australasia
• Greater China
• Southeast Asia
• Leveraged finance
• buyout
• Australia
• China
• Southeast Asia
• KKR
• Pacific Equity Partners
• The Blackstone Group
• Apollo Global Management