Memorandum submitted by Goldman Sachs
I. GOLDMAN SACHSBUSINESS
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
2.1 In recent years, leverage as measured
by debt to EBITDA
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,
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
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.
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.
Avg. Equity Contribution to LBOs
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.
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
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
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.
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.
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 covenantfinancial
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
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.
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
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
IV. THE RISK
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
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
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 packageincluding choices on the level of debt,
repayment profile and financing costis 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
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
Note: 1998 was changed from 36.6% to 35.6% due to the inclusion
of more LBO transactions. Back
Financial Services Authority, Feedback Statement FS 07/03 "Private
equity: a discussion of risk and regulatory engagement",
June 2003 Back
European Central Bank, "Large Banks and Private Equity-Sponsored
Leveraged Buyouts in the EU, April 2007 Back
Ritter, R J "Some factoids about the 2005 IPO Market".