Memorandum submitted by Deutsche Bank
This memorandum is in response to your request,
as set out in your letter to Deutsche Bank ("DB") dated
14 June 2007, for information on the topics of (1) leverage in
private equity deals, (2) the increasing role of "Cov-lite"
loans and (3) risk assessment of private equity LBOs undertaken
before the issuance of debt. The information set out in this memorandum
is provided by Deutsche Bank AG, London Branch.
1.1 Deutsche Bank
DB is one of the leading global investment banks
with a strong and profitable retail and investment banking franchise.
A leader in Europe, the bank is growing in North America, Asia
and key emerging markets. It has approximately 74,000 employees
serving clients in around 75 countries worldwide.
DB offers its clients a broad range of banking
services through its Corporate and Investment Bank (CIB) and Private
Clients and Asset Management (PCAM) franchise. Combining a top
tier investment banking platform with a strong network of global
corporate banking relationships, CIB offers the full product assortment,
including corporate finance and debt and equity underwriting.
In addition, DB has a leading position in international foreign
exchange, fixed-income and equities trading. PCAM provides private
clients with an all-round service, extending from account-keeping
and cash and securities investment advisory to asset management.
Founded in Berlin in 1870 to support the internationalisation
of business and to promote and facilitate trade relations between
Germany, Eastern Europe and overseas markets, DB has developed
into a global provider of financial services. As well as being
the largest bank in Germany, DB is one of the largest investment
banks in the world measured by revenues.
Deutsche Bank Aktiengesellschaft or Deutsche
Bank AG, the group's parent company, is a corporation organised
under German law and its corporate headquarters is in Frankfurt
am Main. With roughly 412,000 shareholders, Deutsche Bank AG is
one of Germany's largest publicly held companies. Its shares are
listed on the Deutsche Borse as well as on the New York Stock
DB's operations throughout the world are regulated
and supervised by the relevant jurisdictions' central banks and
regulatory authorities. The German Federal Financial Supervisory
Authority (known as the BaFin) is DB's principal supervisor. Additionally,
many of the bank's operations outside Germany are regulated by
other authorities. Within countries that are member states of
the European Union, DB's branches generally operate under the
"European Passport". In the UK, DB's London Branch is
also regulated by the Financial Services Authority for the conduct
of UK business.
DB employs over 7,000 people in the UK and its
London Branch operates from the City of London, making it one
of the largest employers within the City.
1.2 DB's European Leveraged Finance business
DB's European Leveraged Finance business is
located in London and forms part of its broader Global Banking
business division. The Leveraged Finance business arranges, underwrites
and/or provides debt finance to or for a range of clients, including
private equity houses, for acquisition, re-financing or other
general corporate purposes. Where the Leveraged Finance business
arranges loan finance or provides an underwritten loan commitment
for or to a client, it would look to syndicate the relevant loan
to a number of lenders, either before or after funding it. Alternatively,
it may help a client raise debt finance by way of the client issuing
and placing bonds with investors in the capital markets, including
to re-finance any loan or commitment to lend which DB has provided.
1.3 Executive Summary
There are a number of factors contributing to
increasing leverage in private equity deals.
Covenant-lite loans are a reasonably new phenomenon
within the European leveraged loan market and it is difficult,
at this stage, to form a definitive view on their future development.
Risk assessment remains an important consideration
for all participants in the private equity sector.
2. LEVERAGE IN
The level of leverage appropriate for a particular
company at any given time is a function of a number of factors
and considerations. These include the general economic outlook
and debt market conditions, together with the nature and needs
of the business itself. A young, developing company may, for example,
have no debt funding, whereas a mature company with a strong cash
flow may be able to sustain a higher level of debt in its capital
2.2 Factors contributing to increasing leverage
Favourable macro-economic trends driving a boom
in corporate earnings and M&A activity
Macro-economic trends in the UK have
been favourable, fuelled by, amongst other things, relatively
low and stable inflation rates and a strong employment market.
From an international perspective,
the US economy has seemingly absorbed a housing market slowdown
and many European companies appear poised to benefit from the
significant growth potential offered by expansion into developing
countries such as Brazil, Russia, India and China.
These trends have contributed to
strong corporate earnings and balance sheets, encouraging a boom
in M&A activity .
Increased LBO activity has not been
restricted to the UK alone, with strong growth across a number
of other European territories (exhibit 1).
Increasing acquisition multiples
Buoyant equity markets and high levels
of M&A activity are driving high company valuations. Most
sectors have returned high positive returns in the last twelve
months or so (exhibit 2). This is evidenced in a corresponding
increase in valuation multiples paid by private equity firms in
LBOs, increasing on average from 7.1x EBITDA (Earnings before
Interest, Tax, Depreciation and Amortisation) in 2002 to 9.3x
EBITDA in Q1 2007 (exhibit 3).
Private equity fund-raising globally
in 2006 reached unprecedented levels (US$432 billion) (exhibit
4). The significant growth in private equity fund sizes is resulting
in strong competition for buy-out targets and higher acquisition
multiples being paid by firms seeking to invest capital.
Significant increase in institutional investor
presence in the leveraged debt markets
The increase in demand for highly
leveraged capital structures is being funded by high levels of
liquidity supplied by an increasing number of institutional investors
such as banks, hedge funds, Collateralised Loan Obligation (CLO)
and Collateralised Debt Obligation (CDO) funds, which are increasingly
investing in the leveraged loan markets in the search for yield
in a low interest rate environment.
In March 2007, there were 275 active
loan investment vehicles in the European leveraged finance market,
compared to only 8 in 2000 (exhibit 5).
Institutional investors are contributing
to the support for higher leverage via increased demand for high
yielding investments in both the senior and subordinated debt
layers of the capital structure.
Payment-in-Kind (PIK) instruments,
for instance, (where interest payments are capitalised or "rolled
up") have emerged as a relatively new class of junior, "non-cash
pay" debt. The senior loan product has also been augmented
through the growth of "second lien" loans. Second lien
financing typically provides second ranking security on the same
collateral as the other senior lenders (but ahead of subordinated
lenders) and, in the event of a security enforcement, will normally
receive realisation proceeds only after the first lien lenders
have been paid in full.
Lender confidence supported by strong credit fundamentals
and risk management
Default rates are at a historic low.
Moody's global speculative-grade default rate fell to 1.57% in
2006 and is at its lowest level since 1981.
Interest on a debt may be paid in
cash ("cash pay" interest) or, alternatively, it can
be capitalised or "rolled up" ("non-cash pay"
interest). The "cash pay" interest cost of debt has
remained stable for large LBOs, despite increasing leverage, primarily
due to larger subordinated debt tranches with a high element of
"non-cash pay" interest, eg such as mezzanine and PIK
debt instruments. This is reflected in stable cash interest cover
ratios in European LBOs (exhibit 6).
The growth in secondary market trading
of leveraged debt provides enhanced liquidity to debt investors.
Market participants nowadays increasingly
actively manage their credit risk through a variety of tools,
including through trading debt in the secondary markets and through
the use of credit derivative instruments such as credit default
Exposure to leveraged credit appears
to be widely diversified and not focused on any particular industry
2.3 The level of leverage
Leverage, on average, in European private equity
deals has increased from 4.4x EBITDA in 2002 to 6.1x EBITDA in
Q1 2007 (exhibit 8). This is primarily due to favourable conditions
driving momentum and liquidity in the M&A and debt markets,
as well as strong credit fundamentals. Leverage multiple expansion
also reflects strong increases in the equity capital markets over
the same period, with the Dow Jones Eurostoxx 50 up 64% (Source:
Capital structures continue to exhibit stable
levels of equity contributions and support from private equity
funds averaging at 30-33% of LBO capitalization (exhibit 9), despite
increasing leverage levels.
On selected recent private equity led transactions,
leverage levels have been seen in excess of the average. While
equity contributions have also been correspondingly lower in certain
transactions, there is no de facto link between increased leverage
and lower equity, with equity contributions frequently seen at
levels in line with the average as a result of high vendor prices.
3.1 Definition of Covenant-lite
While there is no agreed definition of Covenant-lite,
it broadly refers to leveraged loans which have high yield bond-style
financial incurrence covenants only ("pure" Covenant-Lite)
or, alternatively, only one or two traditional loan-style financial
Incurrence covenants generally require that
if a borrower wishes to take a specific action (eg pay a dividend,
make an acquisition or issue more debt), it would need to be in
compliance with specified thresholds at the time the action is
taken. Incurrence covenants have their origins in the high yield
bond markets and typically have for many years featured, and continue
to feature, in high yield bonds, including bonds issued in the
context of LBOs.
Maintenance covenants are typically far more
restrictive, requiring a borrower to meet certain pre-agreed financial
tests every quarter, whether or not it takes a specific action.
Maintenance covenants have their origins in the bank loan market.
3.2 Recent covenant evolution in leveraged
Over the course of recent years, certain maintenance
covenants have ceased to be utilised in leveraged loan documentation.
For example, the Senior debt/EBITDA covenant (which tests the
ratio of senior borrowings as at the end of a financial period
to EBITDA for that period) has not been used on the majority of
deals since 2003.
The majority of leveraged loans to April 2007
have continued to incorporate the following maintenance covenantsa
maximum leverage covenant, a debt service coverage ratio and a
maximum capital expenditure requirement.
Looking at the average number of covenants per
leveraged loan, the erosion to date has not been pronounced, with
transactions launched in the market during the first 5 months
of 2007 containing 3.8 covenants on average, down from 3.9 in
2006, 4.1 in 2005 and 4.2 in 2004 (Source: Standard & Poor's
LCD, 15 June 2007).
The data is, however, historic and many of the
transactions structured with Covenant-lite documentation are only
currently entering the loan market, having been negotiated and
structured earlier in 2007.
Maintenance covenants emerged at a time when
banks began stretching the tenor of their lending. They serve
to alert lenders to financial distress and bring parties to the
negotiating table at an early stage. For leveraged loans with
incurrence covenants, lenders typically will receive monthly management
accounts, so signs of financial distress should be evident to
lenders at an early stage. While there may be no formal trigger
to bring the parties to the negotiating table, maintenance of
a good relationship with debt market participants will remain
an important consideration for borrowers.
Europe has only seen three "pure"
Covenant-lite deals to 31 March 2006 (ie loans with incurrence-based
covenants only) although there are a number of additional cross-border
"pure" Covenant-lite deals due to launch in the next
few months. It is expected that further Covenant-lite deals will
launch in June and July. It is, however, too early to form a definitive
view on the future of pure Covenant-Lite loan transactions.
The use of Covenant-lite can be seen as introducing
flexibility to capital structures, with the result that the inherent
volatility present in certain cyclical industries may no longer
be a barrier to longer-term investment decisions by investors.
3.3 Reasons for growth in Covenant-lite
Influence of the US leveraged loan market
The European leveraged loan market
continues to be strongly influenced by trends in the US leveraged
loan market. Innovative market practices that originate in the
US often become a feature of the European market. In the US, Covenant-lite
loan deals became more common in mid-2006, with many of the target
investors already active in the high yield bond market and therefore
accustomed to incurrence-based covenants.
Shift in lender base
The leveraged loan market in Europe
has evolved over the last 5 years from a market dominated by the
banking community, to a more liquid institutional market with
investors such as CLOs and CDOs investing across all tiers of
the capital structure (excluding the revolving credit facility,
typically made available for working capital purposes, where the
lending commitments have tended to remain in the hands of banks).
This has effectively served to transfer risk from the banking
sector to the institutional lending sector. A number of institutional
investors are accustomed to not having the degree of control and
monitoring which financial maintenance covenants can provide,
as they are also investors in high yield bonds where, as noted,
incurrence covenants have always been the norm.
Supply / demand imbalance and low default rates
Institutional investors have large
cash balances to invest in leveraged loans, given the attractiveness
of the asset class in the current low default environment. The
supply of leveraged loans has not been sufficient to meet this
demand and this has created an attractive environment for borrowers.
Increase in secondary market liquidity
DB estimates that the leveraged loan
trading volume in Europe increased from circa 12 billion
in 2003 to circa 104 billion in 2006. Given the significant
increase in secondary market liquidity, where there has been a
perceived deterioration in the credit of an investment, the high
levels of secondary liquidity have enabled lenders to trade out
of investments that they no longer wish to hold, a mechanism that
has not always been available historically. In addition, emerging
congruence between bank loan and bond style covenants and the
increasing depth of the secondary market has improved the ability
of investors to mark-to-market, with larger numbers of buyers
and sellers at any one time.
4. RISK ASSESSMENT
Risk assessment is clearly an important part
of the LBO process for all of the parties involved, whether for
the private equity house itself, the original underwriter of debt
finance or the lenders who participate in the broader syndication
of the loans. The various participants in this process are sophisticated
and/or professional investors.
In line with many other leading underwriters
and providers of leveraged loans, DB has, for its benefit, internal
procedures and processes in place around its consideration of
whether to commit the bank's capital to provide loan commitments
to support a given LBO.
Before proceeding to make an acquisition, private
equity houses develop a business plan. They also typically commission
or arrange for third party diligence providers to report on a
wide range of issues relating to the target business. This business
plan and these reports are then made available to the arrangers
and underwriters of debt finance for the purposes of their internal
assessment of the proposed LBO and their evaluation as to whether
or not they wish to underwrite all or a portion of the relevant
Private equity houses would also make their
business plans and third party diligence reports available to
potential lenders who are considering whether or not to participate
in the syndication of a leveraged loan. In addition, private equity
houses, through the borrower and in conjunction with the target,
typically prepare an information memorandum on the target business
which is also made available to potential lenders for the same
purpose. In this way, potential lenders can make their own decision
as to whether or not they wish to participate in a given transaction.
Exhibit 1LBO volume has been strong
across the major European territories
Source: Standard & Poor's LCD, May 2007.
Exhibit 2Equity markets have been
buoyant, with positive returns across most sectors
Exhibit 3LBO entry valuation multiples
are increasing as well
Exhibit 42006 private equity fundraising
reached unprecedented levels and exceeded 2005 fundraising by
Exhibit 5March 2007 saw 275 active
loan investment vehicles participate in the European market, a
14% increase in the number of institutional participants in 2006
Exhibit 6Cash interest cover has
remained stable, primarily due to larger subordinated debt tranches
with a high element of PIK interest
Exhibit 7Exposure to leveraged
credit is widely diversified and not focused an any particular
"Of course, [institutional investor] accounts
have learned the lessons of cycles past. The acute sector concentration
that brought the market low in the two prior cyclesretail
in the late 1980s and telecom in the late 1990sno longer
is an issue. Today, the largest sector in the institutional universe
is health care, at 9.3%, followed by automative at 6.4%. Moreover,
the blueprint deals that torched the market in the early 2000s
are not in evidence today. In 2006, just three leverage loans
had negative pro forma ETITDA, or 0.3%. This compares to 5.2%
in 1999, 5.3% in 2000 and 4.6% in 2001."Standard &Poors
Exhibit 9Despite increasing leverage
in LBOs equity contribution has remained stable at 30-33% of LBO
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