Capital Markets

Living with Leverage

In an era of easy money, with increasingly complex debt packages, companies are finding new ways of insuring against a downturn.
Tony McAuleyMarch 14, 2007

Nybron flooring International, a Swiss wood-flooring company with about €400 million ($528 million) a year in sales, was bought for an undisclosed sum last year by private equity firm Vestar Capital Partners, which has its European base in Paris. Vestar financed the deal largely with a debt package of €455 million — around nine times EBITDA — via Credit Suisse, which parceled the debt out to eager, mostly non-bank, lending institutions.

The loan package was split into three senior pieces of €95 million each, a mezzanine loan of €75m, a second-lien loan of €25 million, a revolving credit facility of €40 million, and acquisition finance (a bridge loan) of €30 million. The complexity of the deal, which was completed about a year ago, is fairly typical for private equity buyouts these days. All the elements of the package have various terms and covenants for the different lending syndicates.

In the past year, Nybron hasn’t done as well as it had expected, largely because of the price of raw materials and other external factors. Also, according to Chris Haffenden, an analyst at Debtwire, a market tracker, the flooring company was “bumping up against its debt covenants, though not in breach of any,” and was last month in negotiations in Paris with its banks to revise terms. (Nybron and Vestar officials weren’t available for comment.)

Because Nybron had “consent request” clauses in its debt deals, the holders of senior debt were able to agree without much trouble — and for a fee, rumored to be 0.175 percent — to new terms, but the company was having difficulty getting all the mezzanine lenders on board, according to a source familiar with the negotiations. However, Nybron had the foresight last year to negotiate a “yank the bank” clause into the deal so that it could replace a recalcitrant syndicate lender under certain circumstances when it needs to resolve a debt restructuring.

Pushing the Boundaries

“It’s an extremely aggressive move for a borrower and would be used only in extremely stressed situations,” says the source. But it gives the lending institutions an incentive not to hold up a negotiation.

Such clauses would have been unthinkable for medium-sized European companies a few years ago. Nybron’s situation is an example of both the prevailing extremely borrower-friendly environment, as well as how this environment has pushed back the risk boundaries in the capital markets, both for borrowers and lenders.

Borrowing costs have reached new historical lows; companies’ leverage levels are at historical highs; and the composition of that debt is more complex than ever (see charts).

But few expect the situation to continue indefinitely. “The huge increase in high yield, mezzanine and second-lien issuance means that the number of distressed situations is likely to increase, even in a benign environment,” says Stephen Phillips, a partner in the financial restructuring and insolvency practice of law firm White & Case. “Once you’ve decided to do a deal with seven, eight, nine times leverage, you’re in an inherently risky situation if there is decline in the credit cycle and/or you go off your business plan. What we’re seeing in some of the negotiations is the [private equity] sponsors pushing the lenders for clauses that, while they won’t take that risk away entirely, will mitigate it.”

Snooze and Lose

Also gaining popularity is the “you snooze, you lose” clause. “In a typical credit agreement, a non-reply is a ‘no’ vote for the purpose of a majority lender decision,” David Campbell, a partner on the global loans team at law firm Allen & Overy, explains. “It’s increasingly popular, particularly where arrangers expect to syndicate to a wide investor base outside the traditional bank market, to include a ‘you snooze, you lose’ provision.” This provides that, for majority decisions, investors who do not reply within a certain time period are disregarded when calculating the percentage that approve the decision.

Borrowers negotiating these clauses in the current lending environment know that it can be easy to become complacent. According to Standard & Poor’s (S&P), a credit rating agency, default rates on high-yield bonds — a leading indicator in the credit market — have fallen for 33 consecutive months and were at 1.08 percent in Europe last month, the lowest in 25 years.

The main factor in the debt market is liquidity. Ever-increasing amounts of money are available for lending, from new oil producers around the Caspian Sea and the Middle East, due to high oil prices, not to mention from the rapidly growing economies in Asia. The money is getting channeled through a growing array of lending institutions, such as hedge funds and specialized lending funds, which are competing aggressively with the banks.

“Last year saw institutional investors becoming a much larger component of the sub-investment grade market compared to European banks and I expect that trend to continue this year,” says Fenton Burgin, director of the debt advisory practice at Close Brothers, an investment bank. As big companies borrow less, these institutions are lending to companies further down the food chain on the kind of terms previously only available to blue chips. S&P calculates that these institutions now account for about 40 percent of new lending to European companies.

But the source of the liquidity is also part of the risk. Pierre Cailleteau, chief economic and financial policy analyst at ratings agency Moody’s Investors Service, argues that the biggest threats are a fall in the oil price and a change in the currency policies of China and big Asian exporters. Both of these would be a result of official G7 policy.

“The next round of distress will be very interesting,” says Phillips of White & Case. The clauses being inserted into debt packages now are devices to provide wiggle room in case of slip-ups, but they don’t change the fundamental risk.

“One of the things CFOs [working for private equity owners] sometimes forget is that they have a duty to the company,” Phillips says. “Many feel beholden to the shareholders and that’s natural — the private equity guys call the shots and give them their jobs, and their interests are aligned at the start. But as you move close to the insolvency zone, your eventual owners — and your priorities — can change.”