By Mika J. Lehtimäki, Partner M&A/Finance – TRUST.
I will describe below some recent developments in the Private Equity LBO markets that sophisticated institutional investors should take into account. At the end of this post, I will set out some legal topics that LP investors in Private Equity and LBO debt investors should bear in mind.
What we are seeing in the markets
We have seen a strong inflow of funds into private equity over the last few years. The amount of ‘dry powder’ (i.e. funds that can be called) by the general managers is at the all-time high. No wonder the deal valuations are also at the high end. In addition, the industry’s overall return still remains at ca 7-8% p.a., above double that of e.g. venture capital. Judging from our discussions with the market participants, it appears that the limited partnership-base is relatively satisfied with the incentive structure of private equity and see the asset class with positive outlook.
However, co-investment rights that regained very strong interest last year and the year before that have become rather constrained and, in most cases, may not even feasible for the LP. Any co-investment decision will in effect require independent investment analysis. Our understanding is that under the current market conditions co-investment provisions are usually not approved by the general partners, unless the LP is large investor and has sufficient investment expertise in actual monitoring of the co-investment and capabilities to decide on the matter with a one or two weeks schedule.
On the other hand, leveraged buy-out activity, the level of which has a close link to the liquidity conditions in the markets has no doubt fueled the inflow of capital into private equity. The same applies to the private equity’s LBO debt funding side, which market has seen gradual loosening of debt covenants over the last years coupled with more extensive refinancing options for the debtors and the sponsors, increasing reliance merely on maintenance covenants and strong demand structurally and contractually subordinated debt tranches, and tranches stripped most of their control rights. We have seen numerous LBO transactions and refinancing arrangements where the debtor group and the sponsors have (rightly so) taken advantage of the favorable credit market conditions. One some level a number of the debt instruments appear to seek solely yield, side-stepping the creditor control aspects in restructuring negotiations or enforcement. Furthermore, the CLO market that has once again attained a prominent position and specialist investor groups appear to drive the debt terms more and more towards the US style bond covenants and terms.
On the intercreditor agreement side, the development has not been as clear. What we have encountered is emergence of new types of capital structures combining contractual and structural subordination, senior secured, senior and subordinated high yield tranches as well as super senior working capital facilities. However, these new tranches operate in a roughly same type of an intercreditor framework as the ‘more common’ mezzanine and senior indebtedness classes.
The question whether these new structures work within the contemporary market of dispersed creditor incentives, heterogeneous creditor base and diminishing proportion of bank control has not been tested and any investor whether in the primary or secondary markets should exert extra care in analyzing also the legal aspects of the investment. We have noticed that a careful intercreditor analysis combined with a structured covenant analysis is material in understanding the risk position assumed and devising a plan if and when the debtor group faces financial distress. This is important because the negotiation position of the private equity sponsors has improved in relation to the senior secured creditors (due to more lenient covenants) even though the intercreditor enforcement provisions have remained robust still enabling the senior secured creditor group effect a restructuring upon material default of a covenant.
Despite the clear signs of overheating and the eventual correction whether resulting from interest rate increases, scaling down of the quantitative easing or general market conditions, we see that more experienced private equity sponsors will continue to attract strong interest. Private equity is after all not a single investment but a long-term commitment to a management team for ca 10 years.
What the investors should bear in mind
The fund side
- Pay special attention to Legal DD on general partner incentive structures in the PE Limited Partnership Agreements (especially expenses structures);
- Understand that a co-investment right may not be a feasible option in all circumstances;
- Go through (if possible) the predecessor fund’s LBO investment structures. Is the investment policy geared towards heavy leverage, use of refinancing options, what kind of policy of maintaining creditor control does the GP have (they may be surprised of the question)?
- Does the GP utilize ‘parallel investment vehicles’ and why?
- When has the GP approved co-investment options to LPs?
- How has the GP fares in creditor negotiations in any restructuring of portfolio companies (this goes to the very heart of relationship banking between the lead banks and the PE fund)?
- There is an intense competition of good LBO targets in the markets. How extensive is the professional network of the portfolio managers? Are they able to attract ‘proprietary deals’ or forced to competitive bidding?
- How does the fund’s investment policy (and leverage policy) reflect the possibility of the credit market slowdown?
- How effective and transparent the fund (GP) is in managing conflicts of interest?
The LBO side
- Demand to see the Intercreditor agreement, the capital structure, investment memorandum and naturally the term sheet (or the actual agreements);
- What are the voting thresholds? Will you have any control on the voting within the group?
- Are you investing in the most senior tranche (if so go through the intercreditor enforcement conditions)?
- What are the conditions the debtor group can refinance the debt, is there a call protection?
- Are you structurally subordinated (control very low in practice) or merely contractually subordinated on the same group level as the most senior class? In the latter case, go through the rights of your group against the most senior group in the intercreditor agreement.
- Make a table of the financial covenants and their equity cure provisions; track against the basic risks in the base case analysis and adjust for eventual downturn in the credit/commercial markets. Would you really take the risk with these protections?
- Remember that we saw similar deterioration of the credit terms in 2006 and 2007. As a rule of thumb, either accept a risk of loss of capital/claim upon market downturn / financial distress or ensure that (i) your priority position is high; and (ii) you or the creditor group you represent holds a control position upon a covenants breach. Arbitrage with (distress financing), betting on the loan tranche, seeking a controlling equity position in a distress through debt-equity-swap is extremely hard and requires sophisticated analysis – better to be on the safe side.