LONDON (Reuters) - Private equity firms are increasingly shunning banks to pre-place second-lien loans directly with cash-rich funds, which is reducing banks’ returns as they lose out on the most profitable part of an underwriting fee.
Four buyouts, backed with loans yet to be syndicated in Europe’s leveraged loan market, are expected to include pre-placed second-lien loans, including Danish packaging group Faerch Plast; European industrial supplies distributor IPH Brammer; cleaning business Safetykleen Europe; and Hong Kong-based international schools operator Nord Anglia Education.
By going directly to funds, buyout firms are guaranteeing placement on the most expensive and risky part of a capital structure, avoiding any costly risks that could arise during a syndication process.
“Borrowers are happy to lock in the terms. They don’t have to take market risk with syndication and as second-lien providers can’t get enough of the paper, they are offering competitive terms,” a senior leverage finance banker said.
The removal of a subordinated piece of debt from an underwrite is impacting banks that are already being squeezed on fees on the senior part of a capital structure to around 1.5%-1.75%, from 1.75%-2.25% a couple of years ago. Second-lien fees come in anywhere between 2%-3%.
Subordinated second-lien loans have become attractive to sponsors as a means of increasing overall leverage on a deal, while maintaining control over who holds the paper -- something that cannot be achieved via the public high-yield market.
Second-lien loans also don’t have the restrictive call protection associated with bonds.
Other pre-placed second-liens this year include deals for UK-based Element Materials Technology, Swedish dialysis clinic operator Diaverum, British holiday park operator Parkdean Resorts and Belgian aluminium systems manufacturer Corialis, among others.
Funds available to take pre-placed second-lien loans include Alcentra, Apollo Capital Management, MV Credit, Ares, Park Square Capital, EQT, GSO and Partners Group.
Despite banks losing out on the 2%-3%underwriting fees, sponsors are having to pay out that same amount to the funds they are pre-placing the paper with, in the form of an arrangement fee.
Sponsors are, however, protected from market risk if a deal goes wrong. Typical market flex on a struggling deal could see a sponsor on the hook for an additional 150bp.
“The reality is that there is no real difference in terms of overall fees. The margin may be wider on a pre-placed second-lien loan compared to an underwritten deal, but there is also no flex,” a leverage finance head said.
Deep liquidity in Europe’s leveraged loan market, where demand far outweighs supply, has seen pricing compression. In some cases Single B issuers are achieving market lows of 300bp on first-lien paper and arguably sponsors will achieve market lows on second-lien paper.
KKR paid 675bp over Libor with a 0% floor and 650bp over Euribor with a 0% floor for a $20 million (£15.4 million) and €20 million (£17.3 million) second-lien add-on tranche for UK forensic sciences group LGC in January.
Some banks are approaching sponsors to argue a case for syndicated second-liens. A syndicated deal in such a hot market could price significantly tighter than a pre-placed loan.
However, many of those funds are telling sponsors they will not buy the second-lien paper if it is syndicated.
“Some funds are telling sponsors they will not take second-lien unless it is pre-placed, as all-in yield on syndication is lower. They have remits to do big tickets and they want good yield and a substantial amount of paper. It is a threat but it is a legitimate one because if it goes to a wide syndication and these funds are offered a smaller ticket at a lower yield, they will probably walk away,” the leveraged finance head said.
In a search for yield, there are alternative funds that may be attracted to second-lien paper that may not have otherwise been in different market conditions.
“If banks go to the broader market with second-lien paper there is a base of investors out there in possession of subordinated baskets and in search for yield, so they may be willing to buy,” the leveraged finance head said.
A syndicate head said: “Investors holding sponsors to ransom may be relevant around some very big tranches where you need big ticket commitments but on the smaller second-liens of around €100 million you could sell €10 million - €15 million tickets to various funds.”
Editing by Christopher Mangham