A Climate Shift in Deal Terms
In the first half of 2007 bank leveraged buyout financing was primarily concerned with the distribution risk associated with the selling of underwriters’ commitments. Intense competition in the UK meant it was commonplace for banks to aggressively pitch debt packages to sponsors and agree to sponsors friendly terms with pricing that in some cases did not reflect the credit risk of the deal. There was little need to focus on credit risk as these debts moved quickly off the banks’ books.
This period of easy credit was marked at the extreme in Europe by the adoption of another US trend, “covenant lite” deals. These involved agreements with no restrictive covenants and none of the usual “early warning” monitors, namely financial covenants.
Then the credit squeeze struck. In the second half of the year banks exercised greater caution before entering into a deal, focusing not only on distribution risk but also on credit risk.
What works in the Current Climate?
Despite the shift in deal climate, competition in the UK market remains hot as some arranging banks step up to gain market share, and while the commercial terms have changed, documentary changes to deal terms are not to the extent that one might have expected. Whilst negotiating harder over credit risk protection, banks will agree to terms that are more sponsor friendly provided there is no distribution risk.
It’s the deal economics that really matter now:
• Good credits in recession proof (less cyclical) businesses such as pharmaceuticals, media, mining, energy and infrastructure;
• Deals with lower leverage multiples and therefore conservative covenant headroom;
• Pricing which is more reflective of the credit, for example senior debt in Europe is now priced from 275bps over LIBOR;
• Sponsors contribute 40 to 50 per cent equity to a deal, compared to the lows of 18 per cent a year ago. This also illustrates the current lag between sellers’ expectations and the availability of debt financing.
Historically, the European M&A market has been a sellers’ market with sellers demanding certainty of funding, whereas the US market has been a buyers' market with financing outs, due diligence and material adverse change (MAC) conditions, and reverse break fees that would allow the buyer to walk away from the deal or require sellers to pay break fees to cover buyers’ due diligence costs.
Sponsors in Europe are now increasingly considering requesting MAC conditions to give them an out if there is a MAC in the target’s business and break fees as insurance against costly due diligence processes. Sponsors in the US are now examining their debt packages as they are faced with the risk of losing out to strategic players who are able to offer certainty of funding. One could therefore argue that the credit crunch is causing some convergence between Europe and the US.
As participants try to clear the pipeline from last year and despite growing uncertainty as to the economic fundamentals, we are still seeing deals being done albeit for the right economic terms.