Select Committee on Treasury Written Evidence


Memorandum submitted by Goldman Sachs

I.  GOLDMAN SACHS—BUSINESS AND BACKGROUND

  1.1  Goldman Sachs is a wholesale global investment banking, securities, and investment management firm that provides a wide range of services worldwide to a diversified client base which includes corporations, financial institutions, and governments. Founded in 1869, it is headquartered in New York and maintains offices in major financial centres including London, Frankfurt, Tokyo, and Hong Kong. Our three core businesses are Investment Banking (financial advisory and underwriting services), Trading and Principal Investments (market making in and trading of fixed income and equity products, currencies, commodities, and derivatives and merchant banking), and Asset Management and Securities Services (advisory and financial planning services, prime brokerage, financing services, and securities lending services). With regard to the topic of this specific enquiry, Goldman Sachs both raises its own private equity funds and advises financial sponsors engaged in private equity investment.

II.  IS LEVERAGE EXCESSIVE IN PRIVATE EQUITY DEALS?

  2.1  In recent years, leverage as measured by debt to EBITDA[99] ratios has increased, but it has not increased as measured by debt to total capitalisation ratios At the same time, default rates have remained low during recent years. We do not believe that it necessarily follows that higher leverage levels are inherently excessive, or pose significant systemic risk.

  2.2  It is neither advisable, nor possible, to conceive a one-size-fits-all, "bright line" acceptable maximum leverage ratio. Determining the risk attached to a particular level of leverage for a given company and transaction is a complex assessment. Such risk assessment varies depending on a variety of factors, including the company's industry sector, position in industry cycle, and capital structure.

  2.3  It is strongly in the self interest of private equity firms to engage in good practice of credit and risk management controls for their investments.

  2.4  The past five years have seen substantial growth of the traditional lending market, and its diversification to encompass many types of institutional investor, coupled with the development of new secondary market products, an overall increase in the size and liquidity of the debt markets, against a backdrop of sustained economic growth, low default rates and largely benign financial market conditions. These trends have benefited both borrowers and lenders.

  2.5  However, the new products and the resilience of secondary market liquidity have not yet been tested in a downturn.

  We set out below further relevant background to support these views.

  2.6  The amount of leverage in any particular transaction reflects the borrower's and lender's views on expected interest rate movements and their confidence in the future earnings projections of the borrowing company (which can reflect the following factors, among others: general economic outlook, market developments, and competition).

When analysing leveraged buyout (LBO) financings, lenders tend to rely on the ratio of debt to EBITDA as a primary parameter, but also consider the valuation of the company, and the debt to total capitalisation ratio. Extensive, detailed due diligence is undertaken in all LBOs by both equity and debt providers before the final capital structures are put in place, as described further below.

  2.7  Fifteen years ago, the market principals in the leveraged lending market were mainly commercial banks, which held the loans to maturity. Over the past decade, as deals have increased in size, the attractive potential returns for a perceived level of risk have encouraged a greater number of banks to enter the market, widening the syndication market for such deals. More recently, the leveraged finance market size has grown rapidly with the emergence of collateralised debt obligations (CDOs) and collateralised loan obligations (CLOs) and the entrance of funds investing in credit. The debt market is a professional to professional, primarily institutional market aimed at qualified investors with little if any direct retail involvement or exposure.

  2.8  The convergence between various investor bases and increase in liquidity has increased transparency of the financing markets, as illustrated by the emergence of instruments such as loan credit default swaps.

  2.9  Higher economic growth, a low inflation environment and benign conditions in the credit markets have encouraged a greater volume of transactions with increasing levels of debt finance, often with correspondingly less equity. This trend has perhaps been most notable in the area of private equity, where the attractive returns both in debt and equity have attracted increased amounts of both debt and equity finance. The result of these trends has been reduced financing costs and increased leverage, as measured by debt to EBITDA ratios.

  The chart below shows the evolution of debt to EBITDA in European LBOs over the last 10 years.


  Source: S&P, LCD News.

  2.10  The ratio of debt to total capitalisation used by private equity firms has not changed significantly over the past decade. Over the period 1997-2006, debt to total capitalisation was in the range of 62% to 70% and stood at 66% in 2006.[100] See chart below. Furthermore, when comparing the debt to total capitalisation ratios of companies floated on the stock markets by private equity firms with those of listed blue chip companies, debt to total capitalisation ratios as a percentage of their total assets are not significantly different.[101]

Avg. Equity Contribution to LBOs[102][103]


  Source: S&P, LCD News.

  2.11  The emergence of CDOs and CLOs, the development of a secondary market for loans and favourable economic growth and financial market conditions have together resulted in a wider dispersal of risk and a more liquid market, to the benefit of lenders and borrowers alike.

  2.12  In its recently published Feedback Statement on the Discussion Paper on Private Equity, the Financial Services Authority (FSA) regards possible concerns on "excessive leverage" as a "medium high" area of risk.[104] They recall that they routinely undertake prudential supervision of banks, and that they will continue to conduct their annual survey of leveraged lending activity within the UK (which will become semi-annual in 2008). They state that the robustness of systems and controls is a key focus of supervisors and that this survey will assist them in understanding and keeping pace with the developments in financing leveraged buyout transactions. We believe that these FSA efforts to monitor leverage are appropriate.

  2.13  A recent European Central Bank paper[105] surveyed large bank participation in LBO financing in the EU and potential sources of risk. It concluded that banks' debt exposure to the LBO market is not large relative to banks' capital buffers, but that intense competition and increased leverage levels could have encouraged some market participants to relax credit standards. The study noted that the positive economic and market environment and investors' search for yield led to a wave of financial innovation, creating new borrowing techniques and products. These enable borrowers to match debt more closely to anticipated cash flows and operate at a higher level of balance sheet efficiency and leverage. The market innovations have also made it possible for lenders to spread the risks wider in the financial system. However, the study identifies some pockets of vulnerability. The ECB cautions that if secondary market liquiditydries up, firms' balance sheets might come under pressure. In addition, the new, sophisticated debt instruments have not yet been tested in difficult economic conditions, where they could make it harder to identify who bears the ultimate risk in distressed debt workouts. We share the ECB's assessment of historical trends and current outlook for bank exposures to the LBO market.

  2.14  Borrowing companies and their sponsors have strong incentives to avoid excessive leverage that could not be sustained by the business, since it would have a negative impact on the value of the investment, and a failed investment would cause reputational damage. It is good industry practice to apply strong credit and risk management controls. Participants in the market perform extensive due diligence before engaging in any investing or financing activity. Furthermore, financiers would generally refuse to provide financing for a company that appeared to be over-leveraged, as it would become difficult to syndicate the debt.

  2.15  With regard to the potential failure of highly leveraged companies, we note that the risk of failing companies is not restricted to those backed by private equity firms, or with high leverage. In fact, recent studies have shown that companies backed by private equity firms have outperformed public companies by some measures. In the three years following their IPO, the share price performance of companies that were backed by private equity firms was eleven percent higher than that of public companies.[106] Corporate failure is not necessarily a reflection of ownership, but is often the result of market forces, eg sub-optimal performance of the product or service offered, external circumstances or risks outside a company's control, a faulty business model or failure of management to grow the business sufficiently.

III.  COVENANT LIGHT LOANS

  3.1  The increased use of covenant light loans is partly explained by market developments, reflecting the diversification of market participants beyond traditional bank and mezzanine lenders, negotiation between institutional lenders and borrowers, increased market liquidity permitting easier exit from debt investments and the evolution of alternative means of hedging and mitigating the lending risks.

  3.2  The key question for market participants is the potential impact of a secondary market liquidity crunch on covenant light transactions.

  3.3  An additional challenge is appropriate stress testing for covenant light transactions, given how different each deal is and that the market is too new to have been tested through a down cycle.

  We set out below further relevant background to support these views.

  3.4  A loan agreement typically contains covenants (or conditions) that the borrower must perform. Loan agreements typically have two types of covenant—financial and non-financial covenants. Financial covenants require the borrower to satisfy one or more financial tests, such as a debt to EBITDA ratio, and typically operate in two ways. First, "maintenance" covenants must be satisfied on an ongoing periodic basis (such as quarterly). Second, "incurrence" covenants have to be satisfied only when the borrower wants to engage in a specified transaction, such as borrowing additional money or acquiring another company.

  3.5  Non-financial covenants require, for example the borrower to deliver periodic financial statements and to maintain any licenses necessary to conduct business.

  3.6  If the borrower fails to satisfy a covenant, it may be in default of the loan agreement and the lender may have the right (in some cases only after the expiration of a grace period) to declare the loan immediately due and payable. As a result, lenders are in a position to negotiate with borrowers on their activities, such as the incurrence of additional debt, mergers and acquisitions and transactions with related parties.

  3.7  There has been a recent trend whereby the average number of maintenance covenants has fallen gradually since 2000 (mostly in the US, but increasingly in Europe), which partly reflects a change towards what are commonly known as "covenant light" or "cov-lite" deals, a term reflecting movement toward incurrence-only loan covenants.[107] The increased use of covenant light loans is partly explained by the market developments outlined below.

  3.8  There are broadly two types of investor operating in the leveraged debt markets today: banks and funds. Historically, banks were the only market participants in the loan markets, and they required maintenance covenants to help them police their loans. This approach reflected banks' business strategy, which is to lend money now to be repaid in full and on time at some specified date in the medium term future. Maintenance covenants are designed to track projected financial performance closely, and originally left little room for under-performance against projected performance.

  3.9  Bond investors first invested only in the investment grade markets, and their strategy has always differed from that of the banks. Their priority is payment of yield regularly and on time. Money for such investments comes largely from long term pension and insurance funds. Bond investors require so-called incurrence covenants to protect that yield. These are in many ways less restrictive to a borrower (issuer of a bond) because they merely impose requirements that must be satisfied if the issuer wants to engage in a major event (such as issuance of new debt), and therefore there is no ongoing proof of satisfaction required. Interest rates on an issuer's bonds would commonly be higher than interest rates on the issuer's senior loans, which reflects the covenant protection (as well as other factors such as the relative ranking of the loans and bonds, and any collateral securing the loan).

  3.10  In the past few years as the leveraged finance market has grown, the levels at which maintenance covenants were set for banks' protection have eased. At the same time the influx of institutional investors into the leveraged loan market in search of yield led to changes in the type of covenants in certain transactions. This was possible because the share of banks in the leveraged loan market fell to circa 30%, the rest being made up of various different types of institutional investor (mainly CLOs). Convergence of approach between these different investor types has increased markedly during the past year, and as a result incurrence covenants have begun increasingly to appear in the leveraged loan market, including where banks have participated in these deals.

  3.11  A debt investor in a covenant light transaction is still able to monitor the financial performance of its investment through the monthly distribution of management accounts. This monitoring can and should be more sophisticated than the monitoring offered by following maintenance covenant compliance information. Because maintenance covenants must be satisfied continuously, they are breached when the company's financial performance has deteriorated so that repayment of the debt is in question. As a result, lenders can be involved in decisions of the borrower in advance of the borrower's financial condition becoming critical. The lenders can seek an equity infusion or a debt refinancing, among other options.

  3.12  Incurrence covenants are not designed to give such "early warning" because they do not apply unless the borrower seeks to engage in a transaction subject to an incurrence test. As a result, there is likely to be less time and thus ability for increasingly large syndicates of investors to agree a course of action for a troubled issuer. However these covenant light packages are now more widely accepted because liquidity in the secondary leveraged loan market permits an investor to exit the investment early if it is concerned about its investment in the loan as a result of monitoring the issuer's financial performance as described above. A further mitigant for covenant light loans is that equity levels in LBOs have remained constant on average at over 30% of the capital structure, although minimum equity requirements are set at circa 20% in some cases.

  3.13  The FSA's recently published Feedback Statement on Discussion Paper DP 06/6 "Private equity: a discussion of risk and regulatory engagement" addresses respondent concerns around the perceived risk of covenant weakening. The FSA conclude that they do not propose to take further action outside of their current supervisory process in this area. They understand that the terms of covenant protection are the result of negotiation between investors and borrowers, and that this is driven by market forces including investor demand, competition of investment opportunities, and the supply of new issuance. The FSA states that they will remain focused on the due diligence and risk management controls of lending institutions and support the ongoing industry initiatives in this area. We agree with this approach.

  3.14  The key question for market participants is what the impact may be if secondary market liquidity dries up. Since this is a relatively new market, it has not yet been tested through a down cycle, and there is no established track record of defaults on which to draw for risk modelling. Stress testing for covenant light deals is also challenging because each one is so different. It is possible to stress test secondary market liquidity on a portfolio basis for the recovery value of the debt, factoring in the overall percentage of covenant light loans in the portfolio.

IV.  THE RISK ASSESSMENT OF THE PRIVATE EQUITY LBOS UNDERTAKEN PRIOR TO THE ISSUANCE OF DEBT

  4.1  In our experience, private equity buyers perform comprehensive risk assessments in connection with their investments, including any transaction in which debt is issued, such as a leveraged buyout (LBO). These assessments, in general, cover risks such as certainty of execution, adequacy of investment returns, long-term sustainability of the asset, and reputational issues. A principal focus in such reviews is always the ability to service indebtedness.

  4.2  The risk related to debt is two-fold: accurately determining the sustainable cash flows from operations to service the debt, and ensuring an appropriate level of debt at a predictable financing cost.

  4.3  Both aspects are necessarily addressed thoroughly prior to making any investment or incurring any debt, as described in more detail below.

 (1)   Sustainable cash flows from operations to service debt

  4.4  Private equity buyers typically conduct extensive "due diligence" on each prospective investment in order to maximise their detailed understanding of the business and its sector. They then use this detailed understanding to determine expected future cash flows and to make an informed assessment of immediate and future risks to those cash flows.

  4.5  Most private equity firms, especially the larger ones, typically have an extensive accumulated base of experience which allows them to quickly identify and analyse key risks, and make judgements about them. The due diligence process has become increasingly focused over time as key sector-specific and country-specific risks are crystallised and analysed.

  4.6  The due diligence process is led by an investment team which spends considerable time examining voluminous and precise information relating to the company. This due diligence process is typically supported by experienced professional experts and advisors in areas such as accounting, legal, and finance as well as specialist fields such as environmental, insurance and pensions. Together with these professional advisors, investors use the due diligence process to refine their assessment of any potential investment and its related risks and rewards by examining detailed information on the target company, including significant contracts, management budgets and forecasts, auditors' reports and physical sites prior to making an investment.

  4.7  Commercial due diligence is often supported by global management consulting firms which typically focus on the general economy, relevant market trends and industry conditions, competitors, and key product trends.

  4.8  This analysis forms the basis for determining expected cash flows, which are usually assessed using multiple scenarios to assess the relative risk of different performance trajectories. In addition, the private equity firms interview the company management to validate forecasts whilst assessing the ability of an incumbent management team to deliver the expected cash flows.

  4.9  Particular attention is paid to revenue growth and earnings expectations, as well as the cash required for capital expenditure and working capital to achieve these projections. Financial models are run using various sets of assumptions, including "worst case" revenue growth and profit margin scenarios, in order to understand the sensitivity of associated cash flows and the robustness of the investment case under these scenarios. Depending on the industry, further in-depth simulations may be performed on the impact of industry cyclicality or other difficult to predict events such as technological disruptions. The resilience of company cash flows under these simulations can also take into account potential insulation afforded by niche or proprietary products. A full risk assessment can further incorporate the possibility of stabilising cash flows using hedging to minimize exposures to key variables such as currency exchange rates or raw material prices.

  4.10  Prior to making a final investment decision, the investment team typically presents periodic updates of the investment case and key risks to a fund's "Investment Committee". Most private equity firms have some form of Investment Committee comprised of senior and highly experienced investment professionals, who review and approve or reject investment proposals taking into account all relevant risk and other factors.

  4.11  Separately to the due diligence conducted by the private equity investor, financial intermediaries also perform their own due diligence, adding further checks and balances.

 (2)   An appropriate level of debt at predictable financing cost

  4.12  In order to prudently assess the risk of volatile cash flows being insufficient for debt service, and to create a "safety cushion", private equity funds will normally base a proposed debt package for an LBO on a "bank case", which will contain a more conservative set of cash flow forecasts than the "equity case" used to calculate potential returns to investors in the private equity funds.

  4.13  The most appropriate structuring of the debt package—including choices on the level of debt, repayment profile and financing cost—is usually refined throughout the due diligence process.

  4.14  Parallel to but entirely separate from the private equity investors' due diligence process, sophisticated debt investors will have similar access to due diligence reports and management of the company so they can conduct their own analysis of the company and develop their own view of its prospects, cash flow and ability to service the proposed debt levels. This enables them to demonstrate to their own credit committees that it is sensible to offer a certain debt package based on the facts at hand. The level of debt a private equity sponsor considers appropriate for a particular company may be less than the amount the debt markets are willing to lend.

  4.15  In terms of financing cost predictability, private equity investors typically assess this risk by incorporating in their financial models a general view on the development of base interest rates (eg LIBOR). In addition, prior to closing an investment and issuing any debt a private equity investor will often explore interest rate and currency hedging arrangements which minimise or eliminate any fluctuation of base rates or currency exchange rates for that particular debt package. The financial model will also contemplate the timing and amount of the proposed debt repayment obligations, so that in a worst case scenario of insufficient cumulative cash flows, any so-called "refinancing" risk can be assessed.

  4.16  A comparison of the sustainable cash flows described under item 1 above with the financing costs (including repayment obligations) under item 2 above enables a private equity investor to assess the ultimate risk of cash flows falling short of debt service obligations. Private equity investors and their funding banks often conduct such analyses based on covenants such as "fixed charge cover" (operating cash flow / (interest cost + debt repayment)), even where the envisaged debt package may be covenant light.

  4.17  In order to minimise the potential risk of any investment that is made, and to satisfy the fiduciary duty owed to third party investors in their equity funds, it is customary for private equity firms to undertake a sophisticated and detailed analysis of the type described above before any debt is issued in a private equity transaction.


99   Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) is one of the proxies used by lenders for cash flows. Back

100   Ibid. Back

101   Ibid. Back

102   Equity includes shareholder loans, common equity and preferred stock down streamed to the operating company as common equity as well as vendor note proceeds. Back

103   Note: 1998 was changed from 36.6% to 35.6% due to the inclusion of more LBO transactions. Back

104   Financial Services Authority, Feedback Statement FS 07/03 "Private equity: a discussion of risk and regulatory engagement", June 2003 Back

105   European Central Bank, "Large Banks and Private Equity-Sponsored Leveraged Buyouts in the EU, April 2007 Back

106   Ritter, R J "Some factoids about the 2005 IPO Market". 2006. Back

107   Ibid. Back


 
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