The Changing Investor Menus of Acquisition Finance

Low interest rates have encouraged investors to increase their risk appetite in search of yield. Issuers and arrangers have accommodated them with aggressive deals and financing structures; thereby supporting growing M&A volume. These usually work out until something happens. The August correction is one of those things. Investors, post correction, have paused to reassess their marked down portfolios, and have reduced their risk appetites. This presents problems for unfunded deals structured in the pre correction 1H15, but are only now coming to investors for financing. We previously examined this problem in 2013 with Rue21 in which the loan underwriters incurred large losses.

A current example of the same problem is FULLBEAUTY BRANDS (Beauty). Beauty is an on-line plus sized clothing retailer owned by PE firms Charles and Webster Capital since 2013. In March this year Beauty levered up to pay its owners $215 Mln via a special dividend, and announced plans for a summer $250 Mln IPO. The IPO window was wide open at that time. It subsequently closed late summer resulting in its owners switching to plan B-the sale of the firm. Apax, the same PE firm as in Rue21, agreed to acquire (secondary buyout) Beauty for undisclosed amount funded in part by $1.650B in loans underwritten by JP Morgan Chase, Goldman, Jefferies, and Deutsche.  JP Morgan Chase and Jefferies were also involved in Rue21.

Some details are as follows:

1)     Loan Facilities:

$820 Mln First Lien Term Loan -7 year term at LIBOR+450 BPS

$345 Mln Second Lien Term Loan -8 year term at LIBOR+850 BPS

2)     Leverage

First Lien-4.7X EBITDA

Second Lien (total)-6.7X

3)     Rating “B-“

The loan underwriters are experiencing sluggish demand for the loans based on several factors. First, increased concern over a slowing economy is dragging down retailer prospects. Next, the deal is highly levered at 6.7X, which exceeds bank regulatory guidelines and reduces the potential investor base. Non bank loan investors (CLOs) usually fill the gap, but have suffered portfolio losses during the summer correction. They are becoming more credit quality sensitive-especially toward higher risk second lien loans.

The Beauty loan syndication is still a work in process. The underwriters’ options, absent a rebound in investor risk appetite, are somewhat limited. Attempts to increase loan pricing or reduce leverage are unlikely to be received well by Apax, absent bear market pricing or structural flex provisions. More likely, they will be forced to offer deeper discounts at their expense (loss) and hold larger than planned portions on the loans.

Like war, most of the time acquisition finance is calm and boring. It is, however punctuated by brief moments of terror when investors risk preferences changes.

J