Bankers are devising groundbreaking financing structures to support European leveraged buyouts in their quest to develop the subordinated debt markets. Joanna Hickey reports.

The most notable recent development in Europe’s leveraged buy-out (LBO) loan – or senior debt – market is the inflation of deal size. Transactions are ballooning to unprecedented levels, culminating in Europe’s largest ever buyout, the €5.65bn LBO of Seat in July. This is being driven by high liquidity for leveraged loans, which represent 70% of the overall debt in an LBO financing.

“More banks are participating in leveraged loans as investment grade loan spreads are still quite low. Institutional investors’ capacity is also picking up,” says Mike Ramsay, head of leveraged finance at Prudential M&G.

Rapid evolution

While deal size is the main story for senior debt, the high-yield bond and mezzanine markets – both subordinated debt instruments that rank below senior debt in the capital structure – are undergoing a period of rapid evolution. In their mission to develop a stable and enduring high-yield market and to expand the mezzanine investor base, bankers are creating highly innovative financing structures.

It is in both the sponsors’ and the arrangers’ interests to develop high-yield, which is still an immature, volatile market. For sponsors, bonds are substantially cheaper than mezzanine: a typical Single B credit is priced at about 9.5%, while average mezzanine financing is 14%-15% all-in. Banks earn more through high-yield than through mezzanine because they get paid twice: first for the bridge loan, then for the bond take-out.

“The current innovations are in part driven by arrangers’ attempts to meet high-yield investors’ requirements. Arrangers want to offer sponsors the choice of high-yield as well as senior debt and mezz,” says Christiian Marriott, investor relations director at Mezzanine Management.

The most significant development in Europe’s high-yield market this year is the improved position of bondholders in the capital structure. Previously, the structural subordination of high-yield to senior debt was the European LBO market norm. Senior debt lenders enjoyed total control over restructurings and, as a result, bondholders often lost everything in a default situation.

Christiian Marriott: arrangers want to offer choice

Bondholder security

Following a protracted argument that culminated in the threatened bond buyers’ strike in December 2002, senior lenders are finally allowing bondholders a better security position. Bondholders are now getting a second charge on assets and upstream guarantees from the operating company. “Going forward, there will be no more structurally subordinated bonds,” says Malcolm Stewart, head of leveraged finance at Citigroup.

As a result, Europe is yielding its first crop of second secured bonds. Brake Bros, BSN and Safilo have already come to market this year, while issues for Fiat Avio and Seat are on the way. “The emergence of second secured high-yield bonds is one of this year’s major innovations. On average, these deals are priced 150 basis points lower than subordinated bonds, so the real winner in this is the private equity house,” says Mr Stewart.

In their quest to give bondholders more security, arrangers are creating other brand new debt instruments. The most innovative structure to emerge to date was the Focus Wickes hybrid in July.

Focus was billed as a mix of high-yield and mezzanine, and conceived for sale to both markets. Like mezz, there were upstream guarantees, a second charge over assets and no prepayment protection. Unlike mezz, the notes were listed, with a permanent standstill on security charge and a lengthy 180-day standstill on any guarantees from the operating company after payment default. The pricing, at 11.25% and 12%, was substantially lower than mezz. Ultimately, the deal was placed with high-yield investors, as the pricing proved too low for mezz players.

“Focus was ground-breaking in its attempt to address the needs of all parties and it could be used as a blueprint for future deals,” says Paul McKenna, head of leveraged loans at ING.

Paul McKenna: the Focus Wickes hybrid could be used as a blueprint for future deals

Alternative structures

Bankers are working on alternative structures as well, however. Focus was a secondary buyout, so bondholders were familiar with the company – they would be far less willing to give up call protection for a brand new credit. Also, in all of the second secured bonds seen this year, senior lenders have still controlled all of the security. Bondholders could start to demand an even stronger position. “We will continue to move closer to full contractual subordination, like the US model, where the bonds and senior debt are issued at the same level,” says Stephen Eichenberger, co-head of European leveraged finance at JP Morgan.

Mezzanine manoeuvrings

Meanwhile, the mezzanine market is also producing some pioneering structures, as it expands and starts to converge with the high-yield market. Although mezz exceeding €100m was unheard of just four years ago, tranches of up to €400m are now possible.

Mezzanine has become a real alternative to high-yield. Although in some cases high-yield is preferable for pricing reasons, some sponsors are still choosing mezz as the subordinated debt component in their LBO financings. “Increasingly, financial sponsors in Europe prefer mezzanine. It allows far more flexibility and the investor base is visible and familiar,” says Robin Doumar, head of European mezzanine at Goldman Sachs.

Robin Doumar: ‘Increasingly, financial sponsors in Europe prefer mezzanine’

Warrantless mezz

Traditional mezz is a mix of debt and equity through warrants. However, in the past few years another form of mezz has appeared. To accommodate sponsors’ demands for larger tranches, arrangers have had to go outside the traditional investor base to expand the pool of lenders.

To this end, banks invented warrantless mezz, which is purely debt with a fixed return and lacks the inherent uncertainty of warranted mezz. The fixed returns have attracted a wave of new lenders, including collateralised debt obligations (CDOs) and high-yield investors such as Alliance Capital and Threadneedle.

Traditional investors such as ICG and Indigo Capital dislike warrantless mezz, claiming that the fixed returns do not compensate for the potentially huge upside of warrants. They have often refused to support transactions that are structured in this way. Despite their opposition, warrantless mezz has grown from almost nothing in 1998 to account for more than 50% of all mezz last year, with €2bn of volume compared with €1.424bn warranted mezz, according to Standard & Poor’s leveraged commentary data.

Support is vital

However, in recent months, as mezz tranches have grown ever larger, the support of the traditional investors has become vital to subscribe deals fully. Arrangers are therefore tailoring new features that appeal to the traditional investors.

The non-call option in Viterra’s warrantless deal in June is the most notable example of the renewed catering to traditional investors. Viterra was restructured mid-syndication, at ICG’s request, with a new tranche carrying a two-and-a-half year non-call clause. That was the first time that European mezzanine had restrictive call protection for lenders. In future, more traditional mezz investors are expected to demand call protection to compensate for the lack of equity upside on warrantless mezz.

Dual-tranche mezzanine

Another first this year was the introduction of dual-tranche mezzanine, as seen with Telediffusion de France and Ontex. These structures, which include both warranted and warrantless tranches, are heralded as the ideal compromise because they keep all investors happy, while maintaining the sponsor’s repayment flexibility.

This year, there has also been a steady rise of PIK (payment in kind) preferred notes, which are deeply subordinated junior debt that ranks below mezz and has a 20% average return. “PIK notes are definitely being used more now as a way to boost LBO returns, especially as overall mezz returns are falling,” says Kirk Harrison, head of mezzanine at Barclays Capital.


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