Select Committee on Treasury Written Evidence

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 Exchange.

  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.


2.1.   Background

  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 structure.

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 swaps.

    —  Exposure to leveraged credit appears to be widely diversified and not focused on any particular industry (exhibit 7).

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: Datastream).

  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 maintenance covenants.

  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 loans

  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 covenants—a 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.


  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 debt financing.

  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 1—LBO volume has been strong across the major European territories

  Source: Standard & Poor's LCD, May 2007.

Exhibit 2—Equity markets have been buoyant, with positive returns across most sectors

Exhibit 3—LBO entry valuation multiples are increasing as well

Exhibit 4—2006 private equity fundraising reached unprecedented levels and exceeded 2005 fundraising by 40%

Exhibit 5—March 2007 saw 275 active loan investment vehicles participate in the European market, a 14% increase in the number of institutional participants in 2006

Exhibit 6—Cash interest cover has remained stable, primarily due to larger subordinated debt tranches with a high element of PIK interest

Exhibit 7—Exposure to leveraged credit is widely diversified and not focused an any particular industry

    "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 cycles—retail in the late 1980s and telecom in the late 1990s—no 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 LCD, 2007.

Exhibit 8

Exhibit 9—Despite increasing leverage in LBOs equity contribution has remained stable at 30-33% of LBO capitalisation

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June 2007

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