think

JK: For a period of time earlier this year, credit spreads for second lien and mezzanine financing were sizable: possibly 200/300 bps. With an increase in LIBOR and tightening of the second lien market, we have seen an increase in mezzanine debt in transaction structures. This has also been driven by an increasing leverage marketplace where we have seen more aggressive structuring, 4x/6x/6.5x with HoldCo PIK Notes, necessary to help PEGs finance LBOs.

GH: We've also seen mezzanine providers get more active over the past year by lowering their pricing to the low to mid-teens. They've also shown a willingness to take larger tranches as a way to differentiate themselves. Much of this is generated by the type of investor taking the mezzanine debt. Hedge funds that are typically in second lien tranches are open to unsecured sub-debt to obtain enhanced yields (generally by 2% or 3%). These deals are structured similarly to second lien financings, excluding the security. More traditional mezzanine investors will generally have higher yield requirements and more restrictive terms (i.e., non-call periods, etc.)

JF: The mezzanine market has been very attractive for issuers over the past year as alternative to both second lien and high yield tranches. As compared to second lien, issuers frequently view mezzanine as more patient capital and as mezzanine coupons have trended lower and LIBOR has trended up, pricing is more competitive. Also, as mentioned by others, with the increase in tranche sizes for mezzanine, we have seen mezzanine with "bond-like" covenants and favorable call structures replace some volume in the high yield market.

WPEC: To follow up on Jerome's comment -- have private equity firms become more adamant about who ultimately holds their debt? Furthermore, has this changed the amount of paper you are looking to hold?

JK: Balance sheet management is always something of interest from a lender's perspective. Even in this frothy market our hold sizes continue to be in the $20 million to $30 million range, depending on deal size and PEG preference. PEGs are more interested in who is holding their paper, and it certainly has bearing on who is awarded debt mandates. PEGs want to see their relationship lenders hold more meaningful positions and bank groups don't want to see one or two lenders of a syndicate (for a middle market transaction) control voting. Most PEGs, unless necessary, don't want to see hedge funds leading their deals because of the portfolio management uncertainty or loan to own reputation.

GH: I think the general trend has been for relationship banks to hold less, but we try to hold more to further develop the relationship with the sponsor. Who ultimately holds the debt has become more of an issue in the middle market. Issuers can get good terms from a wide range of institutions so many of them don't want to take the risk of having hedge funds in their syndication group.

JF: The answer varies by private equity group, but if I were to try and generalize, for broadly syndicated transactions we have seen less focus on the final hold positions for the lead arrangers and more focus on allocations to second lien and mezzanine markets. Also, for mezzanine financing, most private equity firms have strong preferences on who is approached for mezzanine opportunities.

WPEC: An industry perception exists that the "mega funds" receive premium terms on their deals because of their brand name and relationships. Does such a premium exist in the middle market? How much does a firm's brand name and your relationship with that firm matter when securing debt for a new transaction or working out a difficult situation with an existing company?

JK: In middle market transactions, I am not sure that either proprietary deal flow or sponsor preferences exist. A PEGs "brand" name may add some cache to the process, but with so much PEG money chasing middle market deals, and recognizing that most PEGs are well banked, I-Bankers and intermediaries can afford to widen the net when representing companies in the sale process. From a debt perspective, I think relationships are important when PEGs are looking to secure financing for their acquisitions. This relationship may be worth 25 bps or a last look at a transaction, which certainly is representative of the increased competition for deals. Relationships are built at the front end, but solidified and maintained based on certainty of execution and delivery. Credibility is key, and that includes behavior from a portfolio perspective. Not all deals go as we all hope and there will inevitably be difficult discussions at some point. Rational thinking is part of relationship building, and PEGs value lenders that act as true partners.

JE: I don't think the middle market gets anywhere near the terms that the mega funds get. We definitely go into a deal with a middle market sponsor with different expectations than when we invest with a mega fund.

GH: Relationships and reputations are important in the middle market -- a well known operator in the space certainly helps syndication. Lenders will stretch further for groups who have a demonstrated track record in a certain industry.

WPEC: Have any of you participated in the growing buyout markets outside the United States? What are the primary differences that lenders must consider in these transactions?

JE: We invest globally, mainly in Europe and Australia. The primary differences with the U.S. relate to creditors' rights if things go badly for the company. The bankruptcy rules are significantly different in other parts of the world, most of which follow "strict priority," which greatly lessens the ability of subordinated lenders to have their voices heard in a restructuring.

JK: Last year we opened an office in London and are looking to capitalize on the growing European LBO marketplace. The European marketplace is different from the States and we have encountered numerous legal challenges. Given the flow of dollars from U.S. PEGs into Europe, we view this as a tremendous opportunity, but recognize this effort is still early stage. We have been primarily a participant in other people's deals to date, but believe we have our first agency role locked up.

WPEC: Do you have any general advice for sponsors when they are dealing with a company that has not performed well and may need to restructure? What can a sponsor do to improve its chances of a successful outcome?

GH: The best advice I can give is to understand the investor base and communicate. Issuers and sponsors who fail to communicate can leave a bad taste in investors' mouths, which will ultimately affect their willingness to bend on certain issues. Be responsive to information requests. Sponsors who keep the lender group informed fair better than those who do not.

JK: I agree. The best advice I have for PEGs that have troubled situations is maintain an open and honest dialogue with your lender. No one wants to be surprised. Don't limit communication to good news. Communication of bad news and a clear plan to seeking a solution is the best course of action. This does not insure a positive outcome, but working together with your lender and keeping all parties apprised is the favored approach.

JE: A sponsor needs to do the right thing. Whether that's putting in new money or working in partnership with the company's creditors, or even handing over the keys to the company -- it's those sponsors that maintain their reputation for acting properly that keep financing sources interested in doing their deals.

JF: I agree with all the points made. Open and honest communication is critical.

WPEC: Have your views on dividend recaps changed in the current environment?

JK: We have done our fair share of dividend recaps and will continue to evaluate them, but pushing the leverage envelope in order to pay dividends is not necessarily something that interests us. Dividend recaps can be a means of retaining solid performing assets in the portfolio. I do like to see PEGs with some level of monetary commitment post recap. While there is still risk, it offers a little added comfort knowing the PEG still has principal exposure.

JE: We will not finance a dividend recap. We believe strongly that the equity sponsor needs to have risk capital in the deal. We've passed on many dividend recaps that have done very well the past few years, but our belief hasn't changed that it's a fundamentally bad investment.

GH: Dividend recaps have grown dramatically over the past three to six months. With so many sponsors currently raising new funds, the need for monetization or partial monetization has increased. Generally, the debt markets will go a bit deeper in the capital structure on an acquisition vs. a recap of the same business. This is due to the validation of value that is provided with an acquisition. In a recap, market value of a business is more subjective. That being said, this is still a great time for sponsors to pursue a recap.