September mega-LBOs to test market capacity, open door for bigger buyouts

29 August 2018
 
A string of giant cross-border LBOs launching next week is set to provide a crucial test of investors’ appetite for risk, amid mounting concerns over the increasing popularity of leveraged loans and the impact of tighter monetary policy on borrowing costs. 

These supersize deals could be a sign of things to come—increasingly large companies are already considering buyouts and will be emboldened to pull the trigger if investors can successfully digest the September supply, according to two senior bankers. 
 
“If you had asked me even two years ago whether we could do a USD 10bn LBO, I would have said, 'no way,'” said a head of leveraged finance at an investment bank. “Now, I have two other potential LBOs in the pipeline that would be at least that big.” 

Among the upcoming deals is the largest levered buyout since the financial crisis: Blackstone’s USD 20bn carveout of Thomson Reuters’ financial news and data division, which will subsequently be renamed Refinitiv

It will be joined by other mega-deals such as Carlyle Group’s EUR 10bn acquisition of paint manufacturer AkzoNobel’s specialty chemicals business and KKR's USD 10bn purchase of Envision Healthcare.  

When these issuers hit the market after the Labor Day holiday, they will encounter a booming leveraged finance market that has sparked a fierce debate over the summer months, as commentators try to square the risk of rising interest costs and an aging credit cycle with growing demand for the asset class.

Investors have poured nearly USD 10bn into loan funds this year, which puts the asset class on track to surpass last year’s total of USD 12.6bn, according to Lipper. 
 
Meanwhile, new CLO issuance so far this year reached roughly USD 80bn as of July, according to Creditflux, partly thanks to the product’s exemption from risk retention rules earlier this year. Wells Fargo analysts are forecasting USD 150bn of issuance by year end, which would surpass 2014’s all-time record of USD 124bn.

With issuers and bankers taking advantage of this ravenous demand to pile on debt—especially since the Trump administration’s suggestion that banks ignore Obama-era lending guidance—the leveraged loan market surpassed USD 1trn in size earlier this year, according to LCD. 

However, that figure does not account for debt that is retained by banks as well as middle-market and private loans, said Matthew Mish, a credit strategist at UBS.
 
“The market is underappreciating the amount of debt that is sensitive to Libor,” he said. 
 
In a recent research piece, Mish and his team estimated total outstanding US speculative grade floating rate debt at USD 3trn, taking into account pro rata facilities as well as their best estimate of middle market and private loans. That figure raised eyebrows among market participants.

“It feels like a new paradigm,” said a leveraged loan analyst at a large asset manager. “We just haven’t had this kind of scale before.” 

Bigger and bolder 

Just as the estimated size of the market has turned heads over recent weeks, market participants are looking to the Refinitiv, AkzoNobel and Envision buyouts for clues as to the capacity and trajectory of the leveraged finance primary market, said several market participants. 

“September will be a case study,” said a portfolio specialist at a leading CLO manager. “While there should be plenty of capacity to take it down, it’s a lot of paper to digest, and the sheer size of these deals could bring volatility.” 

Even bankers—typically more gung-ho than investors about the buyside’s ability to soak up new paper—admit the market is to an extent heading into uncharted waters. 

“The biggest question we have had working on these deals is whether the market can actually absorb transactions of this size,” said the levfin head. 

But if these big transactions clear the market successfully, it could be open season, he added. Emboldened by these large deals, sponsors and issuers are already considering new buyouts on previously unthinkable scale, said the head of levfin and another senior origination banker. 

The list of potential targets for such deals has broadened to include publicly listed mid-cap companies, he added. 

“In the past their options would have been spinning a division off, some kind of partial sale, or selling themselves to a strategic,” the banker said. “But they're waking up to the fact that there is huge depth in the market now.” 

In another sign of that depth, highly valued but cash-burning companies—in other words, not typical users of the leveraged finance markets—are also looking at potential debt issuance, after deals this year from similar companies like UberWeWork and Netflix

“We are seeing increased inquiry around companies like WeWork that have no cash flow but an increasing equity valuation,” said the senior origination banker. 

Pricing pressure 

As always, market participants will be watching the pricing of September’s deals closely to gauge investor demand for larger transactions. 

The US dollar portion of Blackstone’s Refinitiv financing—which is led by BofA Merrill Lynch—is being whispered in the high 300bps-low 400bps area over Libor (5.35%-6.35% at current Libor rates). Whispers for its unsecured US dollar bond are in the 9% area, according to multiple sources familiar with the deal. 

Refinitiv and AkzoNobel both have bank meetings scheduled for next week, while Envision is expected to launch later in September. 

With three large buyouts hitting the market around the same time, pricing for all of them could be pushed wider, said market participants. 

“There’s a real possibility we start to see some spread-widening in these deals in order to clear the market,” said Frank Ossino, a loan portfolio manager at Newfleet Asset Management. 

Average pricing on newly issued first-lien loans has already climbed in recent months, to 383bps in July compared to 325bps in June, according to Debtwire Par’s latest Leveraged Insights report. Upward flexes have also increased—five times as many deals flexed wider than tighter in July, up from twice as many in the first half, according to the report. 

Given the volume of paper that needs to be moved through the market in September, price sensitivity for these large deals could be even higher, said bankers. 

“These kinds of deals are always priced to the last dollar. But pricing to the last dollar on a USD 500m deal is one thing, and pricing to the last dollar on a USD 10bn deal is another,” said the levfin head. “For these deals you need every single investor to play at their maximum size.” 

Covenant concerns 

Familiar concerns around loose documentation and the erosion of investor protections—by now, a well-established feature of the bull market in leveraged finance—are also likely to surround September’s deals during syndication. 

Bankers working on the Refinitiv deal have already fielded a multitude of questions about loose provisions, according to people familiar with the situation. 

Among investors’ fears are Blackstone’s capacity to pay dividends and raise incremental debt—particularly given the potential for the sponsor to buy the remaining 45% of the business from Thomson Reuters, the sources said. 

“The Thomson Reuters deal was put together at a time when the buyside had very little leverage on terms,” said a banker close to the deal. 

However, successful investor pushback on documentation in deals priced over recent weeks could potentially lead to concessions when this transaction and others officially launch in September, said the banker. 

“If you look at the last two months of new money paper, a lot of it eventually priced with changes to the docs, so it’s clear that investors have a bit more power now,” the banker said. 

Broader impact 

A slew of recent analyst reports have highlighted the danger of loose bond and loan covenants in a downturn. For one, Moody’s recently estimated that average first-lien term loan recoveries are expected to fall to 61% from their historical average of 77%, with second lien recoveries set to fall to just 14% from 43% historically.
 
The report cited weaker average ratings on first-time issuers and eroding junior capital cushions, in addition to loans becoming more bond-like.

Compounding these covenant erosions is issuers’ increasing use of add-backs to boost EBITDA. The Refinitiv buyout provides an example of this: based on leverage being marketed at around 5.5x, pro forma EBITDA is roughly 30% higher than the USD 1.7bn the business generated in FY17, according to sources familiar with the deal. A source close to the deal suggested the boost provided by these add-backs would decrease based on the unit’s most recent earnings.

More than half of outstanding leveraged loans were issued with material EBITDA add-backs, according to UBS analysts. Among some of the more aggressive add-backs identified by Debtwire sister company Xtract Research just last month was one allowing a company to add-back the projected EBITDA of new acquisitions based solely on a letter of intent for said acquisitions. 

“These adjusted figures make a real difference because if companies don’t hit those targets, leverage is going to skyrocket,” said a loans trader. 

Buysiders did note, however, that looser investor protections of this kind are nothing new. They have made their way into dozens of recent deals—the difference here is the size of the deals they are attached to, said David Knutson, head of credit research at Schroders. 

“These aren’t just loose covenants in small deals that no one has heard about,” he said. “When you’re talking looser protections in deals this big, that are going to be spread across the market and not just held in a dozen investor portfolios, that has a much wider potential impact.” 
 
Blackstone and BofA declined to comment.