Europe’s leveraged finance markets are running at record issuance volumes — a sign of investors’ keen demand, as quantitative easing has drained the yield out of debt of all kinds. But investors’ levfin portfolios are not growing nearly as much, because a huge chunk of the issuance is merely made up of refinancings of old debt. These deals actually take yield away from investors, as they always come at lower margins than the borrower was paying before.
In 2017, 61% of leveraged loans issued in Europe, the Middle East and Africa from January to September were refinancings, according to Moody’s. In the high yield bond market, it was a staggering 76%.
What investors are longing for is an upsurge in leveraged buy-outs, which would give them some new credits to get their teeth into, in deals that likely offered a bit more yield. Banks also want the chance to make some new long-term clients, instead of being stuck with a stagnating pool of names.
Many are puzzled why this LBO wave has taken so long to arrive, when borrowing conditions are so attractive for PE firms. The gross issuance figures bear this out: €124bn of leveraged loans were priced in the 12 months to September, 116% above the issuance in the whole of 2016, Moody’s data shows. In high yield, borrowers issued almost €90bn of bonds in European currencies from January to November, a new all-time record above 2014’s €84bn, according to JP Morgan.
Leveraged finance issuance could miss those gross issuance volume records in 2018 because so much has been refinanced in recent years, but market participants believe the market will be healthier, as private equity firms engage more earnestly in mergers and acquisitions.
Crucial to the improvement is the economic backdrop. The GDP growth forecast for the eurozone has been revised up to 2% for 2018. Germany is expected to grow at 2%, France at 1.7% and Italy at 1.5%.
“As always happens, when there is an uptick in the economic cycle, M&A confidence surges,” says Tanneguy de Carné, global head of high yield markets at Société Générale in London. “In that sense, 2018 should be a good year. We know that the number of refinancings will be lower in 2018. How we compensate for this will give us the actual picture of the next year. Leveraged buy-outs will be part of that story.”
Money is all around
That view is widely shared in European leveraged finance markets, particularly since some of the best known private equity firms have reached their largest fundraising numbers ever during the past year.
CVC Capital Partners closed a €16bn European fund in May, a record in the sector, after receiving €30bn of demand.
In June, it was Apollo Global Management’s turn to beat Blackstone’s $21bn record fund volume in the US with a new $25bn fund. Apollo’s is the biggest buy-out fund in the world so far.
“There may be around $1tr globally of uninvested dry powder,” says one debt adviser, using the standard industry expression for PE firms’ money available to invest. As he explains, several dynamics explain that mountain: “Company valuations are high, and private equity houses have had several years now of being in a sort of exit phase. Many of them have sold assets. So the average private equity firm has spent the last couple of years in selling mode, and raising funds altogether.”
Many believe private equity sponsors are ready to start investing more of that cash — although with the caveat of an increasingly quiet UK market as its exit from the European Union approaches.
The main thing holding private equity firms back from buying more companies in recent years has been the high prices sellers were demanding. Other industrial companies and the public equity markets were putting high valuations on companies, and PE firms often were simply unwilling to overpay.
But that resistance appears to be weakening. “Sponsors do have vast amounts of money, and are starting to pay those high valuations that were seen as a deterrent a year ago,” says de Carné. “In the second half of 2017, there were already more private equity sponsors active in the markets.”
The debt adviser says that in some recent auctions of companies, the only bidders competing were PE firms.
It’s begun
Indeed, market activity suggests a wave of busier buy-out activity has already begun. While it is true that most of 2017’s levfin issuance was opportunistic refinancing, sponsor-led M&A began to take a bigger share.
Eight of the first nine months of 2017 managed to produce more than €2bn of leveraged buy-out funding in Europe, according to Moody’s. That level was reached in only three months of 2016.
“There has undoubtedly been more M&A across Europe, and a lot of that is the source of new supply in the leveraged finance markets,” says the debt adviser.
Towards the end of the year, especially, some big deals were completed and announced.
When Bain Capital and Cinven bought German pharmaceuticals manufacturer Stada in September, after a long campaign, the €5.3bn leveraged buy-out was the largest private equity acquisition of a European company since 2013.
Then, in November, Verisure, the Swedish security systems group, launched €2.4bn of new five year term loans and €1.15bn of new bonds. This was a refinancing package but it included a whopping €1.05bn dividend to its shareholders, Hellman & Friedman among them — another sign of sponsor boldness.
That same month, Hellman & Friedman displayed a second multibillion deal, all loans, to finance its purchase of a controlling stake in Nordic digital payments leader Nets. It was a cov-lite deal comprising €1.86bn and Nkr2.8bn (€300m) of term loans ‘B’.
And before the end of November, CVC and Blackstone announced Paysafe’s $2.4bn leveraged loan, financing their purchase of it from Old Mutual and Threadneedle.
“The leveraged finance markets in Europe have been buoyed in 2017 by M&A activity led by sponsors, possibly helped by some starting to rethink their expectations over returns,” says Richard Etheridge, associate managing director in leveraged finance at Moody’s in London.
Many private equity executives deny this, but market participants say some of them are willing to buy assets at lower expected returns than they used to demand. That helps them cope with the high valuations sellers demand for some assets.
Other techniques they have used include trying their hardest to originate deals that are not competitively auctioned, often by working with asset sellers for a long time before the sale; and roll-ups — buying a promising company in an industry, often expensively, and then using it to hoover up lesser players more cheaply, so reducing the average earnings multiple paid.
“Private equity groups have a more sophisticated knowledge on how to use their cash,” says Patrice Maffre, global head of acquisition and leveraged finance and head of EMEA financial sponsors at Nomura in London.
The amount of equity funds private equity houses have in their pockets is the obvious enabler of deals. But the strength of debt markets is playing a role, too.
“The M&A pipeline looks good, increasingly populated by sponsors who have a growing pool of liquidity available,” says Maffre. “There is more confidence than ever in the leveraged finance markets, with more pension funds and asset managers gaining bigger commitments [to levfin] or even still building their strategies.”
He argues that this means Europe’s leveraged finance investors have become more able to digest jumbo offerings. “The markets have evolved significantly,” says Maffre. “Investors have shown that they can match sponsors’ enormous amounts of dry powder and confidence to go for bigger deals.”
Private equity firms are also getting smarter in how they use the leveraged finance markets, argues de Carné. The sponsors now have very deep experience of how to combine bonds and loans, sometimes in two currencies or occasionally more, to target particular sections of the investor base.
That is not to say that all signs in the market are bullish. For instance, retail investors took €2bn of cash from high yield funds in the first nine months of 2017, JP Morgan data reveal.
But most market participants argue retail flows make little difference to Europe’s high yield market, where institutional investors buy most of the paper and lead market trends.
And forces at work in the wider debt capital markets have only increased the probability of a rise in LBOs. “It just makes sense, after almost a decade of very low interest rates, and central banks still printing money,” says Richard Kitchen, leveraged finance partner at Paul Hastings in London, who suggests 2018 will be a year busy with sponsor-led M&A.
“When private equity houses start valuing businesses at more than the public markets do, then this must be taken as indicative of the strength of the markets, but also of the amount of money sponsors have. It’s just a matter of time.”
The leveraged finance market has become a more reliable source of funding, private equity firms are more sophisticated, there are more investors across the asset class, and there is a positive macroeconomic background. Maffre’s conclusion seems inevitable: “It’s hard not to be optimistic about sponsor activity for the next months.”