Is the leveraged bid dead?

The outlook for financial sponsors remains positive as BainÆs ability to raise leverage in Asian markets corroborates.
Liquidity in some subprime-affected markets has dried up and financial sponsor deals are feeling the pain. But has Asia decoupled enough from these markets that leveraged deals in the region will continue to flourish while they dwindle elsewhere?

Bankers, economists and investors in the region highlight the now oft-quoted fact that the correlation between economies in the West and those in Asia is much lower then it was in the past, say at the time of the 1997 crisis, and Asian economies are far more domestic demand driven. ôThe (US subprime) situation has no direct fundamental impact on Asian companies and private equity investments in Asia,ö says Manoj Agarwal, head of financial sponsors mergers and acquisitions/equity capital markets for Asia at ABN AMRO.

The specialists including Agarwal are right. But it is also true that private equity deals are at significant risk from even the hint of a liquidity crunch as they involve large amounts of leverage.

ôThe key issue is whether the big money centre banks and bulge bracket investment banks will be impacted in Asia by their outstanding inventory of underwriting exposure in the US and Europe,ö says Eric Mason, managing director in the Carlyle Asia Leveraged Finance team. ôThe question is whether this backlog in terms of underwriting prevents them adding more Asia exposure.ö

Specifically, concerns are being raised that leveraged buy-outs could come to an end as debt markets donÆt have the appetite for this kind of lending in a more risk-sensitive financing environment.

But not all market participants agree with this projection.

And the ability of Bain Capital Partners to put together a debt syndicate for its $2.2 billion takeover of 3Com seems to corroborate this. The deal is driven by 3ComÆs Asia business and H3C. Lenders recognise this and are committing capital.

ABN AMROÆs Agarwal argues that credit tightening is a short-term phenomena. He also observes that the impact will be restricted by the fact that ôleverage multiples in Asia have traditionally been lower than the USö.

Richard Pyvis, CEO of CLSA Capital Partners, says: ôDebt will more accurately reflect risk in the future so riskier deals will become more expensive. Some highly leveraged deals may no longer be financially feasible.ö

Others suggest the situation will prompt an overdue flight to quality. ôLBO is risky lending which needs credit diligence, covenants, appropriate structures, discipline and a strong credit culture,ö says Anand Narayan, head of financial sponsors for Asia at JPMorgan.

The prevailing situation could be a blessing in disguise for some bulge bracket firms who bring credentials and experience to this business.

ôWhile we are seeing credit tighten in the short-term, the recent decrease in valuations, coupled with sensible security terms and strong corporate fundamentals, should augur well for financing over the medium term,ö sums up ABN's Agarwal optimistically.

Local options
The banking systems in some Asian countries are awash with liquidity. ôSome Asian economies like Malaysia, Taiwan and Korea have robust domestic financing markets, which seem quite insulated from the current global trend,ö observes ABN's Agarwal.

Economies in the region are at different levels of maturity with respect to their banking systems. Thus the region includes markets like Australia, Korea and Japan where banks have deep pockets. And, to date, the subprime exposure announced by Asian banks has been limited.

ôBank markets are still open and Asian markets are much more akin to European markets where syndication is largely among banks,ö explains JPMorganÆs Narayan. ôWe are continuing to underwrite deals û the deals we are in the market financing right now corroborate this.ö

Local banks are seeking avenues to deploy funds and are capable of providing finance for buyouts. The participation of Bank of China in the debt syndicate that Citi is leading for the Bain financing is the most recent example.

ôAsia can still provide significant levels of credit for buyouts,ö agrees CarlyleÆs Mason.

The region has also seen enhanced focus from international banks and most firms in the region have beefed up their leveraged finance capabilities.

Covenant-lite packages
There also seems to be broad agreement that covenant-lite packages are out of favour in the region. Most loans in the market are back to the traditional structures with both maintenance and incurrence covenants. But market participants also suggest that there was more talk than action surrounding covenant-lite.

ôSomething can not really æcome and goÆ if it never really came in the first place,ö observes CarlyleÆs Mason. ôThe concept [of covenant-lite] was not really tested in Asia. What is clear is that such borrower-friendly structures are probably off the table for most new deals in all markets for the time being.ö

The recent past, until just before the subprime mortgage nervousness, had seen the balance of power shift from lenders to borrowers. Borrowers were raising debt on very favourable terms, due primarily to intense competition among banks to build up assets. That situation has now corrected as banks start taking a long, hard look at the risks again. And one way of ensuring risk protection is to have covenants in the terms.

But sources suggest this is not a cause for alarm. Sponsors may not get funding on terms as accommodating as they may have wished for, but equally, banks in the region will lend on ôsensible termsö.

ôFinancing costs will not change drastically,ö elaborates a banker. ôFundamentally there is a central bank bias across the region to reduce interest rates; further, risk premiums in the region are not increasing.ö

Good for Asia?
Allocations to Asia out of existing funds are expected to increase. Further, sponsors are still raising Asia-dedicated funds. On October 2, Morgan Stanley Private Equity Asia announced it had closed its third fund of $1.5 billion dedicated to the region. And other private equity firms are following suit.

Participants are also hopeful that the situation could accelerate the development of new instruments in the market. ôIf there is going to be one standout beneficiary of the re-assessment of risk in the region, it will be mezzanine which bridges the widening gap between equity and senior debt,ö says CLSAÆs Pyvis.

Asia is currently a term-loan market but most participants believe that the region will benefit from both a widening and deepening of the market.

ôAs sponsors continue to compete tenaciously for new deals, the need for more specialised capital structures to enhance their returns has become a competitive and strategic imperative,ö explains CarlyleÆs Mason.

The outlook is still positive
ôThe underlying rationale that private equity firms create value in investee companies remains unchanged and the sentiment remains positive in Asia,ö says JPMorganÆs Narayan.

The debt markets could tighten temporarily, leading to a slowdown in private equity deals, but it will be a temporary lull.

CLSAÆs Pyvis sums up his views on Asia: ôWe strongly believe in our underlying investment hypothesis: there are a billion baby boomers emerging with growing per capita GDP, purchasing power and consumption demand which in turn will lead to growth in investment, and demand for capital.ö

This is part of a feature which appeared in the September issue of FinanceAsia magazine.
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