2. ANALYSIS
2.1. G LOBAL LBO TRENDS
Deals and targets
Overall M&A market is strongly correlated with economic cycles. As seen on Graph 5 below during economic downturns M&A activity decreases to minimum. This is due to availability of funds and ability of merging companies to extract synergy effects from the transaction. Financial markets are unwilling to accept new HY bonds issues in the downturn as they are prone to interest rates movements and investors are picky in regards of investments and their default rates. Synergies in post-deal period are mostly gained thanks to lying off abundant administrative employees and shutting down plants whose production can be transferred to other locations. These activities are publicly disapproved during contractions of economy but overseen during expansions.
Year 2006 was by all means record breaking for M&A industry. Previous records from tech-boom period were shattered and sent to oblivion. 2006 saw several mega deals in various industries with telecommunications leading the pack (similarly to 2000 when AOL – Time Warner merger happened). The biggest deal was acquisition of BellSouth by AT&T for USD 83.4 billion which was basically reversal of regulatory ordered demerger of AT&T. Acquisition was approved this year on basis of changing telecommunications market, in order to enable AT&T compete with other giants in cable, triple-play and internet markets35. Other notable deals were in energy sector (EON acquiring Endesa for USD 66.1 billion and Suez acquiring Gaz de France for USD 43.1 billion), very public acquisition of Arcelor by Mittal Steel for consideration of USD 39.5 billion and financial sector.
35 Same development is seen in Central Europe as UPC acquisition of second its second largest competitor was approved by regulatory office. Reasoning was similar with emphasis on increased competition by telecommunications firms.
Many industry experts expect 2007 to be another record breaker. This is supported by still prosperous economy (although US economy is expected to slow down, Europe was in 2006 for the second time in row top M&A market), still seriously unconsolidated European industries (banking, airlines etc.) and abundance of capital held by private equity funds and offered by banks for financing.
Graph 5: M&A market development
Source: Saigol and Politi (21 December 2006) and New York Times (5 January 2007) based on Dealogic reports.
Buyouts lead by private equity funds developed in accordance with total M&A and we should not be surprised if buyouts will surpass threshold of one trillion in next year. As seen on the graph below global buyouts deal value grows exponentially with US holding dominant position with deals accounting for 56 % of total buyouts. This trend should continue as private equity funds raised enormous amounts of capital in 2006 (USD 400bn) and thus have approximately USD 700bn available for investment36. If we take into account that on average today’s deals are two thirds debt and one third equity and that all needs for debt by private equity would be accommodated, we can expect USD 2.1 trillion of funds available (ceteris paribus). It would be no surprise if share of buyouts on global M&A deal value would reach 25 % within 2 years.
36 New York Times (5 January 2007)
Graph 6: Buyouts development and share of total M&A deals.
Source: Saigol and Politi (21 December 2006) based on Dealogic reports.
2006 set new records not only in total deal value but also in terms of size of the leveraged transactions to date. Multibillion dollar deals were announced throughout the year and longstanding record of KKR acquisition of RJR Nabisco from 1989 was surpassed at least twice. First by KKR together with Bain Capital and Merrill Lynch Global Private Equity as they announced USD 33bn acquisition of HCA (hospital chain) and later by Blackstone Group which acquired Equity Office Properties for USD 32.5bn37. If late 1980s prompted calls of “barbarians at the gates”, today we should be shouting “barbarians are within the city”. Trend of ever bigger companies being acquired by private equity houses should continue and furthermore it should spill into Europe.
From the above stated we are able to derive two more important observations. First, in past two years buyout funds started assembling syndicates in order to be able to put together funds necessary for acquisition of huge companies. For example already mentioned HCA acquisition required USD 10.5bn38 of equity finance in order to complete the deal. Even though recently raised funds are able to lure billions of dollars from investors it is very risky to invest half of your money into one investment.
37 In fact seven of top ten leveraged buyouts of all time (by deal value) took place in 2006 (New York Times, 5 January 2007)
38 Moody’s (19 October 2006)
Therefore club deals take place as resources are pooled. Club deal syndicate can combine resources of three to seven investors.
This is entirely new territory as buyout firms are used to operate on lone ranger basis.
Lone riders find companies fitting their portfolio and / or specialization provide equity and institute small boards of target companies which interact with management in solving upcoming issues. Club deal requires larger board of directors as each investor wants his representative and also there is bigger threat of different mind set of
“clubbers”. Every investor can prepare his own strategy in order to reach his desired IRR and thus investors can clash, eventually bringing company into default position.
Lone ranger can easily steer wheel of the company in accordance to his intended strategy and goal. Only if syndicated investors clear their positions in regards of strategy for targeted company before transaction takes place and stick to it, they should easily avoid future problems. This can be done for example via appointing syndicate leader who is responsible for management of the company and reaching strategic goals.
On the other hand “clubbing” enables syndicate participants besides already mentioned diversification of risk, ability to go after bigger companies and decrease level of competition in bidding process. If the ability to quickly respond to challenges (which is main advantage of private ownership compared to public ownership) is diluted by clubbing will be seen in first crisis which is still pending.
Second development observed from above stated trend of bigger companies being acquired by private equity, is focus of buyout houses on publicly traded companies.
Taking private transactions exploded with unprecedented activity in 2005 and 2006.
While in 2004 public to private transactions amounted to USD 18bn in 2005 it was already USD 69bn (mostly due to taking private of Hertz – car rental company (consideration of USD 15bn), SunGard Data Systems (consideration of USD 11.3bn) and Toys “R” Us – toys producer (consideration of USD 8.8bn)39 and in 2006 this was surpassed by only three deals involving then publicly traded HCA, Equity Office Properties and VNU (Dutch media research company). With such pace we can expect first 100bn buyout no later then 2007.
In order to utilize their funds private equity companies dare to look on bigger targets than before. Most suitable place to look for such targets is stock exchange. Busting of
39 Bank of America (2006c)
tech bubble and subsequent bear market of early 2000s only encouraged them. Taking private is ideal exit strategy from public scrutiny for undervalued companies overseen by analysts and neglected by investors, or companies lagging market for several years.
On the other hand private equity is ideal for stripping those companies of non-core activities and cost cutting needed to be undertaken in order for turnaround.
Smaller and middle market companies have often realized that being private brings too high costs incurred in order to comply with regulatory requirements. These were only increased by Sarbanes-Oxley act. First intended to increase reliability of financial reports and thus publicly traded companies after Enron scandals, it is now denounced as overburdening and hampering stock market development. Of course if company is going private only due to Sarbanes-Oxley, it means something is wrong.
After several years of ignorance, technology buyouts are becoming again one of the favorite exercises of buyers40. Recently data gathering companies, chip makers, software providers, electronic commerce systems and other hardware and software manufacturers were targeted in buyouts. Such development is happening only after convincing of the finance providers that their income streams are stable and sufficiently diversified in order to withstand volatile lifecycle of the industry. Taking into account above mentioned expectations in regards of deal size development we can expect industry peers to be subject of leveraged buyouts, for example underperforming and struggling companies as SunMicrosystems, or Dell and other well known brands.
Besides hardware technology which is fairly new industry to be considered as potential target we see greater diversification of buyouts around economy. As internet bubble burst and telecommunications and Silicon Valley firms cleared itself private equity investors are ready to give it a second try. Also utilities (especially in emerging markets), energy companies and finance industry are being considered by private equity.
40 Blaydon and Wainwright (29 September 2006)
Graph 7: Global multiples development.
-2 4 6 8 10
1999 2000 2001 2002 2003 2004 2005 2006
year
Purchase price to EBITDA
0 1 2 3 4 5
Debt to EBITDA
Purchase price to EBITDA Debt to EBITDA
Source: Bank of America (2006d)
As seen on the graph above recent cycle of M&A activity drove multiples of leveraged transactions into this century record levels. Although they would appear high we should not forget that; (i) Debt to EBITDA multiple is still slightly below levels from the end of 1990s and (ii) Purchase price to EBITDA multiple although at highest level seen in a decade it still lags significantly levels all time highs in 10-11 range. Long-term average of Purchase price to EBITDA multiple oscillates between 6 and 7. From the above we can conclude that as the multiples have room to increase, at least in 2007 we should see further buyout activity setting new records.
Graph 8: European multiples development.
-1.5 3.0 4.5 6.0 7.5 9.0
2001/2002 2003 2004 2005 2006
year
Purchase price to EBITDA
0 1 2 3 4 5 6
Debt to EBITDA
Purchase price to EBITDA Debt to EBITDA
Source: Fitch (5 April 2006).
European transaction and debt multiples showed similar development as global ones and therefore we can expect same progress into future.
European deal financing trends
After dealing with trends in transactions as well as potential target orientation now we will elaborate on funding needs of transactions and funds.
As shown on graph below, High Yields experienced significant boom in past four years recovering from 2000 meltdown. In contrary to overall M&A market development HY are not so strongly correlated with economic activity. Surge from 2003 can be contributed to increase of post recession refinancing activities of conglomerates (e.g.
Ford and other automakers issued HY bonds as they needed finances to compensate for huge losses). Only spike in 2006 can be contributed to buyouts activity as it corresponds with significant increase in average issue (see Graph 9).
Graph 9: Global High Yield debt issuance.
Source: Saigol and Politi (21 December 2006) based on Dealogic reports.
Average issue size shows similar development as total issuance. 2006 increase should be contributed to increased buyouts activity which needed higher debt (see description of deals announced in 2006 above). almost unique usage, took of in 2001 and since then increased number of deals by 3.6 times. Value issued as mezzanine finance was slightly less than 5.5 times higher in 10 months 2006 than entire year 2001. 40 percent average year on year increase is caused
by explosion of European buyouts. Quick growth should continue and mezzanine share on total buyout financing should continue to rise in the following years. This is of course still mainly due to very small mezzanine position, which will be further
Source: Oakley (16 November 2006) and ING (September 2005).
Growth is caused by inflow of new investors into mezzanine segment of the market, stronger competition of mezzanine against HY bonds in terms of spreads, structure and investors’ focus.
Investors like flexibility of mezzanine financing as debt issued is tailored according to needs of the investor (size, period etc.) and it is callable immediately. This is the main distinction of both instruments as HY bonds have call protection inserted (usually up to first 5 years). Private equity uses this flexibility for refinancing of the debt as soon as possible if market conditions develop in favor of this.
On the other hand to have option to call the debt when advantageous they have to pay higher interest. Yield spreads (above government bonds) are approximately 900 basis points in regards of mezzanine and approximately 600 basis points for HY rated CCC minus (one level above default)41.
41 Oakley (16 November 2006)
Graph 12: European HY debt issuance.
Source: Fitch (30 May 2006) and Oakley (16 November 2006).
Although HY market grew strongly over the period from 2001 to 2006 (23.6 percent) it was outpaced by more than 14 percent by mezzanine market. Development of HY is much more volatile than and by far not as straightforward as in mezzanine.
Significant role plays replacement cycle of bonds as they are issued in waves. During first couple of years investors demand call protection in order to ensure their revenue streams. After this period they are either called or held up to their maturity. Restriction on continuous flow and replacement of bonds can create bottlenecks and thus trend of replacing and issuing new trenches can differentiate from the trend of M&A cycle.
If comparing both sides of Atlantic Ocean in issue size of HY, US dwarfs Europe as Europe represents oscillates around 12 percent throughout reviewed period with only 2004 hike up to 14 percent range. This further confirms old truth about much more developed capital markets in US than in Europe and reliance of American firms upon them as provider of financing. In Europe banks and bank syndicates have stronger position in providing financing for LBO and companies in general.
On the other hand HY is by far bigger market as there is much more investors available and willing to acquire HY bonds into their portfolios, which is main advantage of this instrument over mezzanine. Much bigger pool of investors involved with HY bonds enables companies to raise debt issues in amount exceeding EUR 1bn. We should
notice that on small and middle level competition of mezzanine and HY is strong and investors have a genuine choice.
Above stated is confirmed by our findings shown on graph below. As can be observed average debt issue of HY bonds is almost three times higher than mezzanine issue. We should not forget that issuance of HY includes non-LBO transactions.
Graph 13: European average issuance comparison.
-50 100 150 200 250 300 350 400
2003 2004 2005 2006*
year
EUR m
High Yield Mezzanine
* Calculated as of November 2006.
Default rates of HY bonds are low both in US and Europe as well but are expected to increase in next two years. Trend is caused by positive economic development with stable growth and by loosening of banks position on debt and loan issues. Leveraged transactions compile large portions of HY issuance and due to LBO issuers nature virtually no defaults are expected in first two years after bonds issue. Recapitalization which will be described later has been another factor in favor of low default rates. Tide should change in next two years as LBO transaction issues of HY bonds hit their post problematic period. Recapitalization enabled by too liquid markets can postpone such development for further year but increase of default rates is inevitable. In table below we provide basic characteristic of default rates and their development over several past years. Due to time constrains no data for 2006 are provided.
Table 2: European default rates.
2001 2002 2003 2004 2005 2006
Default rate (%) 8.9 25.1 6.4 0.6 0.5 0.3*
No. of default issuers 18 28 9 1 3 n/a
Default volume (EUR bn.) 4.1 19.4 5.7 0.6 0.7 n/a
*First quarter of 2006
Source: Fitch (May 2006) and Fitch (June 2006)
US default rates are slightly higher but also of almost no significance. Comparison of European and US default rates is provided in the graph below. We should not forget that US HY market is much bigger than the European counterpart which is strikingly obvious on defaults size.
Graph 14: Default rates comparison.
-1 2 3 4 5 6 7
2003 2004 2005
year
Default rate (%)
Europe US
Another trend which needs to be highlighted is shortening of investment cycle of the companies in portfolios of private equity investors. With increased liquidity of financial markets private equity starts to look for “quick buck”. There are two main ways to earn it; recapitalization of company’s debt and complete exit from the company usually via secondary or tertiary buyout (to another private equity investor).
Recapitalization is done mainly in order to capitalize on low interest rates and cheap debt available today. If company undertakes recapitalization it means that it will issue
and with the proceeds it will repay it previous loans and bonds issues and / or use them for payment of dividends to its owners in so called dividend recap. Proceeds from debt issue are in such case used to pay out dividends to owners and through that to private equity funds partners. Dividend recaps are especially favorable if company is not yet ready for sale and / or market is not in favorable constellation which enables private equity investor to realize desired IRR.
Consequences of such move should be considered very thoroughly and due diligence process is usually desired precaution. Only companies with little or no debt (which is fairly unlikely if investor is private equity firm) or with good credit history and cash flow generation should undertake dividend recap. In such recap investors can receive up to whole amount invested but usually it is slightly less (e.g. Fitch study found that up to 77 percent of invested funds was returned to investors through dividend recaps in 2005, up from 64 percent in 200442).
It is no surprise that investors increase their ability to extract money out of the company in order to repay invested capital but much more surprising is that they are able to do it in even shorter time than previously. Time to recycling of transactions decreased from 31 months in 2004 to 28 months in 2005. This means that private equity firms are not willing to wait for first returns obligatory three years as in the past. Trend should further continue as is confirmed by several recaps within 12 months after acquisition of the company.
So called recycled LBOs are in fact sales to other financial investors in secondary or higher buyout. Although private equity firms used to had three and more years investment possession in order to add value and increase potential price, today encouraged by willingness of highly liquid investors, they are ready to sell their companies sooner. Of course this means that multiples of exit-to-entry prices would be lower than those held longer (Fitch study found multiples of 2.9 of initial investment on 66 examined transactions over span of 2004 and 2005, which transforms into 36 percent IRR43).
Also it should be noted that recaps and quick exits leave companies significantly more leveraged than previous deal. As seen in table below all leveraged multiples increase.
42 Fitch (January 2006)
43 Fitch (January 2006)
What can be contributed to the fact of overall multiple increase (described above) and what to fact of secondary debt restructuring we leave up for the discussion. Please notice that increase in secondary debt restructuring between 2004 and 2005 is higher than overall increase stated in first part of this chapter. It can be interpreted as overshooting of private equity investors and threat for future of the companies.
What can be contributed to the fact of overall multiple increase (described above) and what to fact of secondary debt restructuring we leave up for the discussion. Please notice that increase in secondary debt restructuring between 2004 and 2005 is higher than overall increase stated in first part of this chapter. It can be interpreted as overshooting of private equity investors and threat for future of the companies.