Bankers keep eye on cap rates in high-yield M&A trades

Fri Jul 19, 2013 10:49am EDT

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July 19 (IFR) - As US Treasuries have stabilized and yields tighten anew, bankers are optimistic that pending M&A trades in the US high-yield bond market will find strong demand from investors - and not hurt the underwriters bringing the deals to market.

Some major LBO and merger & acquisition deals are in the works, including for US pork giant Smithfield Foods and industrial machinery maker Gardner Denver, and market participants are hopeful that the recent bout of volatility that sent rates surging is under control, and won't have any further negative impact on the transactions.

Bond underwriters set so-called cap rates on new issues - effectively, the level beyond a bond's pricing at which they agree to purchase the remainder of the new bonds that investors do not buy - and generally give themselves an additional 150bp to 200bp of cushion when doing so.

But this has proved to be tricky of late because mergers and acquisitions take much more time to arrange than the simple selling of debt - meaning that recent and upcoming deals were planned before the recent surge in rates.

For example, Valeant Pharmaceuticals, the last large M&A issuer to tap the high-yield market, nearly approached its cap rate. The USD1.625bn eight-year non-call three senior unsecured notes tranche, part of the financing for Valeant's purchase of Bausch and Lomb, priced in late June at 7.5%. This was heard to have been around just 25bp under its cap in the high 7% range.

If banks don't syndicate out a new issue and have to price it at a rate over the cap, they swallow the extra costs. And if they syndicate out the bridge loan to the buyside, then it's the investors who suffer if the follow up bond prices over the cap rate.

To avoid getting stuck, bankers have lately been moving up the cap rates by as much as 200bp. An LBO deal that was expected to price at 7% with a 9% cap rate, for example, may now come with a 8.5% or even 9% coupon expectation and a 10.50% or 11% cap.

"Investment banks are going back to the ultimate issuers with higher caps, so it's up to the issuer to decide how much they are willing to bear in market risk," said one investor.

While some issuers appear to have decided that's too much - some would-be borrowers have simply bowed out of recent deals - others see value in doing deals now before rates, as is widely anticipated, move still higher in the weeks ahead.

For now, though, at least some cap-tapping fears appear to have lessened now as the market has tightened back in over 100bp in the past few weeks, according to the Barclays high-yield index. And some bankers estimate that upcoming M&A deals have at least 100bp of cap room available.

"I think we've recaptured most of the losses," said a high-yield syndicate manager. "There is probably more selectivity from investors on deals than before, but overall we've recaptured a lot of the losses and there is less concern that we are hitting the caps."

Many in the market are paying particular attention to the upcoming deal from Gardner Denver, which is being seen as the new bellwether for where LBO risk prices.

The company on Wednesday announced its USD675m bond offering to partially fund its USD3.9bn LBO by KKR. Expected to price next week, the eight-year non-call three senior notes, rated Caa1/B-, were initially being whispered at an unofficial high 8% area.

The last LBO deal of size in the market was the HJ Heinz USD3.1bn 7.5-year B1/BB- rated offering that priced at a very low 4.25% in March, while the McGraw-Hill Global Education Holdings USD800m B2/BB rated bond offering, also priced in March as part of its LBO by Apollo, was sold at 9.75% at a discount to yield 10%.

Already, Gardner Denver's USD2.725bn loan, launched last Tuesday as part of the financing, is over-subscribed, with pricing being ratcheted lower on Thursday. This could translate into a lowering of the bond costs as well.

"Gardner Denver will be a good test of the market as to where to price that kind of risk," said one banker.

Market participants will also look to that deal for signs that LBO paper can get done at reasonable rates now, which may encourage issuers to step in sooner than anticipated in order to avoid the possibility of more volatility in the autumn - when the Fed is widely expected to begin tapering its bond buying program.

Indeed, as the tone stabilizes, with the yield-to-worst falling swiftly back down to 5.89% as of Thursday from a recent high of 6.97% on June 25 and the yield on the 10-year US Treasury falling back to a 2.50% range after spiking to a recent high of 2.75%, some of these deals could possibly be pulled ahead of Labor Day, market sources speculated.

"If we see Gardner Denver, which is the first LBO out of this bunch to go, clear in the low 8% range, then I think other issuers may want to get their deal done sooner instead of waiting," said a second banker. He added, however, that if an issuer thinks its deal can still get done within its cap in the autumn, there is little reason to price it earlier than anticipated.

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