Over-heated buyout market set to create wave of
opportunities for distressed investment
Tuesday 20 November 2007
A significant number of over-levered buyouts are
expected to crumble in the next two to three years and create a
surge of distressed investment opportunities, according to new
research released today by Grant Thornton and Latham &
Watkins.
In a survey of 110 senior lending bankers, CLO managers, hedge
funds and private equity executives in the UK and Europe, more than
half (51%) predict at least 10% of leveraged buyouts (LBOs) will be
acquired by distressed debt investors in the next two years,
including a quarter who predict more than 20% of LBOs will be
purchased by distressed investors during this period.
To put this in context, the majority of those surveyed (60%)
estimate at least 20% of LBO credits are over-levered today.
Mark Byers, Head of Restructuring at Grant Thornton, said the
firm has already seen investors prepare for this shift as they set
up dedicated distressed teams to identify and grasp opportunities
in the distressed debt market.
"With deal flows also predicted to fall next year, it is highly
likely that distressed investing could make up an even greater
proportion of overall opportunities in the next 18 months. For
those with the ability to move quickly, assign a sensible value and
assess a distressed investment's turnaround prospects, this
environment represents a significant and lucrative opportunity,"
Byers said.
But there is still reluctance in the vast majority of buyout
firms to even explore these opportunities. Just 28% of executives
are planning any change of strategy in light of the recent turn in
the credit markets.
Breaking down the attitudes of the various respondent groups,
unsurprisingly it seems the hedge fund community is the group
backing a boom in distressed investing, with 41% of hedge fund
respondents expecting a fifth of LBO credits to breach covenants in
the next three years. Least expectant, however, are CLO managers
and banks, where just 5% and 7% of respondents respectively believe
breaches of more than 20% of credits are likely within three
years.
James Chesterman, London Chair of Banking and Finance at Latham
& Watkins, said his firm had been watching the position from
both the leveraged finance and restructuring/distressed investing
side globally.
"Whilst currently hedge funds can see discounts on secondary
syndication providing returns now, we foresee the combination of
the continuing credit crunch and a potentially weakening US economy
as putting more stress on highly leveraged deals creating
opportunities for distressed investors over the next 12-18 months,"
Chesterman said.
Survey respondents also painted a bleak picture for future LBOs,
with an overwhelming 94% of those surveyed expecting a decline of
at least 10% in deal volumes in 2008. In total, 55% of respondents
believe that LBO deal flow will wane by at least 30%. In terms of
value, 86% of respondents expected a decrease in company
valuations.
There is also significant variation in forecasts on deal flow
based on deal size, with mega-deals singled out as the hardest hit
by the ongoing credit squeeze. In fact, 84% of those surveyed
predict a fall in volume for these deals, while 64% expect there to
be a decline in public-to-private transactions, which make up a
significant proportion of these mega-deals. Conversely, just 10% of
respondents envisage problems for mid-cap deals.
In terms of new debt issuance and deal structures, respondents
predict several key shifts in 2008. A significant 79% expect
leverage on LBOs to fall to an average of 5-7x EBITDA in 2008,
which is down from the lofty leverage levels witnessed pre-credit
crunch this summer. In tandem with reduced leverage comes larger
equity contributions, with three-fifths of respondents believing
the average equity contribution to an LBO will be higher than 40%
in 2008.
The source of debt funding for LBOs is also likely to change
rapidly, according to respondents. Two thirds anticipate a
diminishing role for second lien, and increased reliance on senior
and subordinated issuance, while the frequency of payment in kind
(PIK) notes and covenant-lite financings is expected to almost dry
up completely while liquidity remains an issue.
Looking to the immediate future, however, Grant Thornton's Byers
issued a positive note for those lenders beginning to examine the
over-levered companies in their portfolios.
"The importance of a timely, proactive approach by both borrower
and lender is undeniable, and even if current credit issues deepen,
early action based on frank communication and advice will still
offer the best chance of a successful, sustainable recovery," Byers
concluded.