Maintaining price discipline in leveraged finance
Asia’s leveraged finance market sees bright future ahead but rising asset valuations amid increased liquidity remain a concern
co-founding managing partner, Capital Square Partners
head, Asia-Pacific financing group, Australia, Credit Suisse
head, syndication and distribution,
Asia-Pacific financing group, Credit Suisse
head, structured finance and principal investment,
Huatai Financial Holdings (Hong Kong)
partner, Linklaters, Singapore
managing director and head, group investment bank, United Overseas Bank
head, mergers & acquisitions and sponsor finance, Asia, Sumitomo Mitsui Banking Corporation
Editor-in-Chief, The Asset
The leveraged finance volume in Asia reached US$13.5 billion in 2018, slowing from two years ago when volume stood at US$15 billion.
This comes as the deal flow slackened last year in markets such as China, while sponsors were stymied by the prevailing high valuation. “We did not see that many leveraged buyout deals out of China last year and most of the financing were related to outbound M&A transactions,” says Sergio Morita, head of syndication and distribution for Asia-Pacific financing group at Credit Suisse. “The leveraged finance market in Australia was very active and India as well, but it was also extremely competitive.”
Japan saw a number of transactions, but as most of the deals were in the local currency, it was difficult for non-Japanese banks to participate. Singapore and Indonesia were less active, with deals few and far between.
“We had high expectations with the amount of dry powder available, but there were not a lot of deals closed in 2018. The credit markets had been strong with investors, banks and funds willing to do deals,” says Adam Roberts-Thomson, head of Asia-Pacific financing group for Australia at Credit Suisse.
Despite heightened market volatility last year, liquidity was not an issue, especially with the large amount of funds raised by the private equity houses. “There was a decent amount of liquidity in 2018, but the banks were saying there were not as many deals as 18 months ago. That was our experience as well,” says Christopher Bradley, a partner at law firm Linklaters in Singapore. “There were also different types of deals, but not pure leveraged, and that is sort of pushing the amount of debt into deals.”
With the available liquidity in the market, the banks’ appetite for leveraged finance deals was high as Mukesh Sharda, co-founding managing partner at Capital Square Partners, points out. What concerns him, though, was the price being paid for some of the assets. “For larger deals, people are talking about a much higher multiple on the Ebitda (earnings before interest, taxes, depreciation and amortization) as leverage. What is the reason behind this? It is due to the total amount of money raised by private equity houses. They have more money to deploy and as a result, are bidding the asset prices up,” says Sharda.
Ryan Chung, head of structured finance and principal investment at Huatai Financial Holdings (Hong Kong), saw opportunities in direct lending or mezzanine finance. Chinese corporates are facing challenges to secure onshore guarantees amid regulatory constraint, making it difficult for offshore banks to provide senior debt. “This again created a window for us since we can take higher risks through the provision of mezzanine financing,” Chung says.
However, Chung adds, the Chinese sponsors are still not used to mezzanine financing. “It will take a lot of education for us to squeeze that piece of leverage.”
Mezzanine financing, according to Sharda, is playing a significant role in leveraged finance deals. “In a lot of the deals that we do, mezzanine financing is a component that we employ, and the number of mezzanine providers that we now have has increased quite a bit in the past five years,” he says. “There are large institutions, including private equity houses that are themselves setting up mezzanine funds, which also have the capability to do unitranche-type of deals – something that is not being done often in Asia, outside of Australia.”
Sharda notes these non-bank credit institutions have the ability to offer senior debt and mezzanine financing, and since they can offer a blended rate, it actually works out very well. “We are able to deliver a higher internal rate of return because of the big contribution from both the mezzanine tranche and the senior debt tranche,” he adds.
For Chung, mezzanine financing is much more transparent now in terms of pricing. “There is a lot more mezzanine providers in the market, and sometimes, even a general partner without experience can raise a private credit fund,” he notes. “They are diluting the market and I feel a lot of pricing pressure, although this is being offset by the increasing base rate.”
Australia, meanwhile, is witnessing an interesting scenario with leveraged finance deals as banks, according to Roberts Thomson, were often asked by sponsors to help them understand alternatives across three structures.
The first one is the US term B loan market with first lien, second lien – with or without an Australian dollar tranche. The next one is local bank plus mezzanine market and the third is an Australian dollar unitranche. “They all have various features and options on leverage and terms,” says Roberts-Thomson.
Sharda says unitranche sounds very attractive – less hassle and it is more flexible. “While I am not seeing much of it in Asia, institutions are talking to me about it,” he adds. “I have not seen a strong term sheet with regards to that, but I clearly see its merits and I love to engage such kind of structure.”
With regards to term B loan, it used to be that if a borrower could not get a refinancing done in Asia, they could tap the term B loan market, says Morita. “The difference now is that even for good deals, borrowers would like to see pricing for a term B loan at the outset as one of the potential refinancing options,” he says.
For Sharda, while term B loan is covenant lite, pricing-wise, it does pose certain complexities. He explains: “When you want to restructure something, do an M&A and want to raise more debt, trying to get the approval and the processing done with the term B loan gets complicated. Whereas if you have a group of banks syndicating the loan, it is easy to get an approval for an M&A, and the banks are very dynamic. It provides you with a lot of flexibility.”
Apart from the large amount of capital raised by private equity houses, what is also fuelling the liquidity in the leveraged finance market was the aggressiveness of the domestic banks in Asia in providing leveraged loans.
These banks are familiar with the corporates, their businesses and their management and are comfortable in putting together a leveraged kind of capital structure with terms that are closer to what they do on a corporate level.
Such deals are happening in China, Japan, Korea and Taiwan, making it difficult for foreign banks to enter these markets.
These domestic banks are also arranging leveraged loans outside of their home market – and they are fairly aggressive in doing so.
This was exemplified by United Overseas Bank (UOB) of Singapore, which arranged a deal in 2018 in Hong Kong, solely underwriting a US$2 billion financing deal to back Gaw Capital in acquiring The Link Reit portfolio.
“It was not an easy call to make given that we are not a Hong Kong domestic bank,” says Edmund Leong, managing director and head of group investment bank at UOB. “But we were able to step up for the client, which needed the funding certainty, and managed to bring in a couple of sub-underwriters post deal announcement.”
In arranging transactions, Leong says UOB will consider sole underwriting if they are very confident that they can de-risk from such deal. “Any sole underwriter should not be greedy as we need to make sure that we have the ability to very quickly bring in the sub-underwriters and launch the transaction into syndication,” he says. “If you price and structure the deal properly, you can actually move the risk.”
“We are selective about the deals we do on a sole basis. We focus on markets and clients that we know well and where there is a strategic use of proceeds,” adds Morita.
In Australia, the emergence of non-bank players taking market share is an emerging theme. Compared to those in other markets in Asia, sponsors in Australia have different funding options such as unitranche debt, term B loan and senior bank debt.
Another trend in the market is the rise of retail players. Leong is seeing a return of retail players, setting up shops and forming leveraged finance teams. This reminded him of the market nearly 15 years ago when such trend also took place. “This is good because many leveraged finance deals were closed within the first stage of syndication,” he says. “It is always nice to have another stage of syndication to get more participants into the deal. Potentially, these participants could also come and do this as a private placement – being able to deploy longer-dated paper.”
Amid the robust market liquidity, Bradley says valuations on leveraged finance transactions are going up and that is actually dragging up the amount of debt that is needed to put into transactions to make them work from the sponsors’ perspective.
Morita agrees: “We’re getting to a point in the market cycle where there is a lot of liquidity, whether it be debt or equity – this seems to be one of the factors driving up valuations.”
Such amount of liquidity, in Morita’s view, also leads to a lack of discipline. He explains: “In some sectors, you see sponsors trying to bid for assets at levels that are hard to justify going with that kind of leverage. It is unlikely that anyone coming in can increase the value of some of those businesses so significantly, after multiple private equity firms would have already cut costs and explored synergies.”
“We need to maintain price discipline in terms of buying assets. We have to make sure that we focus on that and whatever excess liquidity driving the asset prices up. We do not have to do a lot of deals,” adds Sharda.
Going forward, the outlook is positive for the leveraged finance market. “With the corrections in equity markets and many target stocks, strong capacity of sponsors and constructive credit markets, we are optimistic for the LBO activity in 2019,” says Roberts-Thomson.
“We have a healthy pipeline. We are seeing a lot of sponsor-led activity – a mix of native Asian sponsors and some international sponsors,” adds Morita.