Bankers who finance leveraged buyouts are helping private equity firms tiptoe back to the credit markets. But they’re not buying into the recent euphoria.
Many of Wall Street’s biggest underwriters were forced to mark down the value of their loan portfolios as the pandemic sent stocks and other risk assets into a tailspin in March, leading to a nearly two-month freeze in dealmaking. As conditions improve, the lenders are building better protections into LBOs they sign up for, including those for Spanish phone provider Masmovil Ibercom SA and pet products company Radio Systems Corp.
Their newfound caution may seem at odds with the ebullient state of credit markets. Junk bonds have recouped nearly all of their losses this year, and more than $100 billion of the high-risk securites have been sold since the beginning of April. But for debt with the lowest ratings -- the jet fuel in private equity deals -- the rebound has been slower, keeping lenders on edge.
The leveraged loan market, long favored by private equity firms to fund LBOs, has also lagged. The largest buyers of the debt -- vehicles known as collateralized loan obligations -- are not purchasing as much as they used to as they deal with the wave of downgrades that has hit many of the companies they already hold.
New Vintage
Only a handful of new buyouts have been announced since the March meltdown, including the Masmovil deal and Clayton Dubilier & Rice’s acquisition of Radio Systems, which makes dog-training collars.
Terms on those deals, as well as others that are still being negotiated, paint a clear picture of banks’ wish lists for Covid LBOs: less leverage, more bonds and greater flexibility to sell the debt at steep discounts if needed.
The around 3 billion euros ($3.39 billion) of secured debt that banks agreed to provide to KKR & Co., Cinven and Providence Equity Partners for Masmovil consists mostly of high-yield bonds and allows banks more leeway than usual to adjust pricing and structure through syndication, according to people with knowledge of the matter who asked not to be named because the terms are confidential.
Barclays Plc, BNP Paribas SA and Morgan Stanley provided the initial debt commitments, though more banks are expected to be added to the group later, the people said.
CD&R had initially sought to finance its acquisition of Radio Systems with first- and second-lien loans and leverage of over six times a measure of earnings, according to a separate person. It later pivoted to an all-bond structure that puts leverage closer to five times, the same person said. A group of banks led by UBS Group AG ultimately agreed to provide financing for the deal.
Representatives for Barclays, BNP Paribas, Cinven, KKR, Masmovil, Morgan Stanley, Providence and UBS declined to comment. CD&R and Radio Systems didn’t respond to requests for comment.
Big Buffers
To avoid eating into the fees they earn to underwrite the debt or, in the worst-case scenario, taking outright losses, banks have been including bigger buffers, known as market flex, into the terms of their commitments.
Banks are seeking flexibility to syndicate loans at rates that are as much as two percentage points higher than those they initially indicate to borrowers, compared to 1.25 to 1.50 percentage points of flex before Covid, the people said.
With investors demanding lower initial prices on risky debt, the type of loans that banks used to backstop at around 97 cents on the dollar are now being underwritten in the low 90s, the people said. Big discounts can be particularly attractive to CLOs that are looking for quick returns on newly issued debt to repair their portfolios.
For bonds, the interest rates that determine when banks start eating into their fees have risen to 11% or 12%, even for secured notes, compared to below 10% before Covid, they added. That’s even as other LBO bonds currently trade at yields of around 8%.
Still Worried
Bankers first turned cautious in late February, when the virus was already spreading through Europe but before any shutdowns began in the U.S.
One of the last deals to be signed during that time, a $295 million loan for CD&R’s acquisition of British health-care services company Huntsworth Plc, was also underwritten in the low 90s, some of the people said.
Royal Bank of Canada and Barclays funded the deal in May to allow the acquisition to close and may bring it to the broadly syndicated market over the coming weeks, according to one of the people. Representatives for RBC and Huntsworth declined to comment.
Bankers’ reluctance to loosen underwriting terms as markets have rebounded shows that much of Wall Street is still worried about new spikes in volatility and the pace of the economic recovery amid signs the virus is still spreading.
They have reason to be cautious.
A group of banks led by Jefferies Financial Group Inc. is beginning to market a $945 million loan for TSG Consumer Partners’ purchase of Pathway Vet Alliance after being forced to fund the deal with their own cash earlier this year, according to people with knowledge of the matter. Representatives for Jefferies and TSG didn’t immediately respond to requests for comment.
And two of the largest commitments that were signed before Covid-19 -- $9.4 billion of debt for the buyout of Thyssenkrupp AG’s elevator unit and $7.2 billion of loans and bonds for Eldorado Resorts Inc.’s acquisition of Caesars Entertainment Corp. -- are still stuck on banks’ books.
