2013 How to Finance Small and Middle-Market Private Equity Deals in Belgium?

Joris Van Gool
Under supervision of Professor Paul A. Gompers

H A R VA R D

BU S I NE S S

S C HO O L

INTRODUCTION

Why this study?
This study assesses, at the beginning of 2013, how do small and middle-market private-equity (PE) deals in Belgium get financed and which future changes can be expected. There is ongoing talk on how the prolonged credit and sovereign crisis is changing the way European leveraged buyouts (LBOs) get financed. Due to stricter Basel III regulation and a general deleveraging trend, European banks are expected to reduce their balance sheets with EUR 2-3 trillion post-crisis.1 As a result, banks have been reducing debt exposure across most lending categories, including private equity-backed companies.2 Current collateralized loan obligation (CLO) funds, which were mainly raised in 2006-2007 with seven-year investment periods, are still active in the market for mid-market and large deals. However, they are expected to wind down in the next years with only one new European CLO launched since 2008 by March 2013.3 On the non-bank financing side, several credit funds have launched vehicles to step in a possible European lending gap.4 Corporate bond issuances, including high-yield bonds, have also been on the rise in end 2012-early 2013, partly replacing bank-loan financing. However, public bond issuances are mainly refinancings for larger issuers and come less to the benefit of acquisition finance of small and middle-market deals.5 While it is uncertain how the specifics will play out, the traditional bank-based model of European LBO financing will continue to be challenged. While the Belgian LBO debt market is only a fraction of the European market, it is a particularly interesting case. The Belgian banking market has historically been exceptionally large (bank assets were ca. 470% of GDP in 2006 versus Euro-area average of ca. 250%) and strongly concentrated (top 4 banks represented ca. 80% of the market in 2006). What’s more, all major banks underwent important changes over the past years: Fortis was integrated in the French BNP Paribas bank and split off its insurance activities, Dexia got nationalized and refocused its activities as Belfius, KBC got bailed out and refocused on retail and small-business customers, ING split its insurance and banking activities but retains commercial banking as a core activity.6 In this context, Belgium is an interesting case to assess what happens with the financing of small and middle-market LBOs in a historically bank-dominant market that undergoes major change.

iii

How to Finance Small and Middle-Market Private Equity Deals in Belgium?

Approach
To assess how small and middle-market PE deals in Belgium are getting financed, this study followed a parallel approach of data analysis and interviews: An analysis of a sample of 68 Belgiani deals in the 2005-2007 and 2010-2012 periods for which sufficient details are available and which are smaller than EUR 400 million enterprise value has been conducted. Data has been sourced from ThomsonReuters, DealScan, Debtwire, Mergermarket, CapitalStructure, KvK, NBB, Preqin, CapitalIQ, Unquote and news articles. Data has been enriched with proprietary data from cooperating funds and banks. n Next, more than 15 interviews of private equity executives (Bencis, E-Capital, Ergon, Gilde, Gimv, NPM, Vendis, Waterland) and senior leveraged finance bankers (Belfius, BNP Paribas Fortis, ING, KBC, Morgan Stanley) have been conducted.
n

For any comments or questions, please feel free to contact me at: jvangool@mba2013.hbs.edu. Joris Van Gool Boston, May 2013

i

Small deals are defined as deal value (enterprise value) < EUR 50 million; middle-market deals are defined as deal value > EUR 50 million and < EUR 400 million. Where possible, the sample focuses on Belgian deals. For selected metrics the sample had to be expanded to Benelux deals and deals in EUR 400-500 million range to enlarge sample size. iv

TABLE OF CONTENTS

1. Which State of the World Are We In? 1.1. Anno 2013 in Belgium: Disconnected Buyers and Sellers 1.2. Abundance of Debt – or Only For a Few? 1.3. Future Private Equity Returns Will Be Lower 2. How is Post-Crisis Deal Financing Different from Pre-Crisis? 2.1. Capital Structures and Conditions of Financing Have Changed 2.2. Who Provides Financing: Four Main Banks Dominate Again 2.3. Non-Bank Lending Alternatives Ramping Up? 2.4. Will Amends & Extends Remain Friendly?  2.5. Wrap-up: Winners & Losers 3. How Could the Future Look Like? 3.1. Move To a Rise in Non-Bank Financing? 3.2. What Do We Need to Believe?

1 1 4 7 9 9 12 14 16 17 19 19 21

Afterword23 Endnotes25

v

1. WHICH STATE OF THE WORLD ARE WE IN?

1.1.  Anno 2013 in Belgium: Disconnected Buyers and Sellers
“With a lot of cash in everyone’s pocket, there is definitely competition for good assets, which drives prices up.” --- Private Equity Executive “The bid-ask spread between buyers and sellers is high, very high. Only for the best assets, common ground can be found. Other assets are just not being traded.” --- Banking Executive

When comparing 2010-2012 with 2005-2007 (“pre-crisis”), the conclusion is clear: a smaller number of buyout deals is being completed (see Figure 1), at historically high multiples and with lower leverage than pre-crisis.

FIGURE 1: I nvestments - Value and number of buyouts dropped significantly in 2010-2012 versus 2007 EUR billion (equity value); No. of transactions – Belgian deals only 1.60 Equity value -34% 1.08 0.63 0.75 17 35 -40% 24 21 No. of transactions

2007

...

2010

2011

2012

2007

...

2010

2011

2012

NOTE: Excludes growth deals which remained stable in deal value at EUR 130-200 million and increased in number of deals SOURCE: European Private Equity and Venture Capital Association (EVCA) Yearbook

1

How to Finance Small and Middle-Market Private Equity Deals in Belgium?

Figure 2 shows that the average multiples paid in 2010-12 are high from an historic perspective. The average enterprise value (EV)/EBITDA multiple of 7.3x in 2012 even exceeds the 7.2x peak-level of 2007. Downward price pressure, resulting from more negative post-crisis business forecasts, seems trumped by the upward forces. Interestingly, this trend seems universal across Europe, with the 2012 average European EV/EBITDA level of 9.6x approaching the 2007 all-timehigh of 9.7x.ii

FIGURE 2:  EV/EBITDA level of PE deals in 2010-12 is as high as it was pre-crisis EV/EBITDA multiple – Belgian deals only Average - PE deals 7.2x 5.2x 7.1x 7.3x

5.4x

6.4x

2005

2006

2007

...

2010

2011

2012

NOTE: Part of data derived from published annual accounts and extrapolated from historic figures SOURCE: Report data sample

Why the small number of highly-priced deals? The interviewees indicated that the main bottleneck to do PE-deals in Belgium is the pricing disconnect between buyers and sellers, which causes that only a small number of high quality-assets trade at generally high prices. Many assets remain on the sidelines as no common value agreement can be found. The high prices paid are said to be the result of the high-quality nature of the assets being traded and the large amount of financial and strategic buyer cash waiting on the sidelines.

ii

The European average includes large deals as reported by Dealogic7

2

1. WHICH STATE OF THE WORLD ARE WE IN?

How did Belgian company valuations outside of PE evolve over the past years? A quick look at public market valuations of Belgian middle-market companies (see Figure 3) shows that there has been a pricing correction in public markets in 2010-11 which has been much more outspoken than the private equity pricing correction shown in Figure 2. The stability in the PE market might indicate that the quality of PE-assets traded might indeed have been consistently high, where the public market valuations reflect an average quality of assets.iii

FIGURE 3: P  ublic-market valuations fell back from pre-crisis peak-levels, but have been recovering in 2012 EV/EBITDA multiple – Belgian deals only 12.4x 12.0x 13.1x 7.9x 5.5x 9.4x Average - BelMid Cap Index

2005

2006

2007

...

2010

2011

2012

NOTE: Data sample limited for 2012 multiple SOURCE: Bloomberg (includes companies such as Deceuninck, Hamon Groep, I.R.I.S. Groep, IBA, Jensen Groep, …)

How significant is the upwards price-effect of dry powder waiting on the sidelines? Figure 4 indicates that of the small and mid-market funds with a focus on Belgium, 10 have raised their most recent fund in 2010-12, while only 3 of them are still investing from a 2006-2008-vehicle. The majority of dry powder on the market is therefore from relatively young vintages and is expected to not yet have the “burning” effect of older capital that is close to expiration. It should be noted that a significant pool of more than EUR 1 billion of “older” capital is still floating around, with at least a partial focus on Belgium. The price-increasing effect of this pool of capital is expected to be small however as the majority comes from funds with a relatively broad geographic focus area.

iii

The significantly higher valuation of publicly listed companies versus PE-deals is striking. A possible reason for this discrepancy includes: the average publicly listed mid-cap company is significantly larger and more established than the average small or middle-market PE deal and therefore trades at a higher valuation. 3

How to Finance Small and Middle-Market Private Equity Deals in Belgium?

FIGURE 4: T  he majority of dry powder targeted for the Belgian market is from 2011, a young vintage. There is a significant pool of older capital waiting on the sidelines as well.
No. of most recent “main” funds raised per vintage year; EUR million (dry powder in 2013) per vintage year x
No. of funds raised Dry powder est., 2013

2

0

1

3

2

7

1

3,574

821 0 2006 2007 237 2008

941 412 2009 2010 2011 76 2012

NOTE: Most recent “main” fundraising vintage considered per PE fund. Funds: 3i, AAC, Avedon, Bencis, E-Capital, Ergon, Gilde Buy Out, Gilde Equity Management, Gilde Healthcare, Gimv, Groupe Alpha, H2 Equity, Nimbus, QAT, Vendis, Waterland SOURCE: Preqin

1.2. Abundance of Debt – or Only For a Few?
“Deals of 5.5x Debt/EBITDA leverage are appearing again. And banks are willing to participate.” --- Private Equity Executive “I have not seen a deal not take place because of financing problems. Credit committees have been asking extra conditions however.” --- Banking Executive

“I often hear that the decrease in leverage is not that much. I disagree with this. Going from 27% to 40% equity contribution is almost a 50% increase! In which other industry do you see input requirements rise with 50%?” --- Private Equity Executive

Belgian LBO financing markets seem to be wrestling with contradicting realities. On one hand, average LBO leverage levels have significantly gone done and politicians are planning for the launch of a “people’s bond” to cope with the demands of companies for better access to financing.8

4

1. WHICH STATE OF THE WORLD ARE WE IN?

On the other hand, Belgian corporate bonds are being issued in record-speed at record-low prices and highly-levered debt packages are available again for selected transactions. LBO debt financing While the interviewees unanimously indicated that debt financing is currently not a limiting factor to do deals in Belgium, Figure 5 pinpoints to a striking reality: average equity/EV levels are around 40% and higher in 2010-2012 versus levels of 30% and lower in 2007. As will be further detailed in this study, average leverage levels and debt conditions have generally become stricter than they were pre-crisis in the small and middle-market.

FIGURE 5:  Higher equity contribution post-crisis, with debt levels increasing again in 2011-12 Share of enterprise value (EV), % - Benelux Delta in equity contribution: +18 p.p. 100 80 60 40 20 0 2005
SOURCE: Report data sample

Debt, % of EV Equity, % of EV 100% 100% 100%

100%

100%

100%

74

71

73

56

59

60

26

29 2006

27 2007 ...

44

41

40

2010

2011

2012

How strong are the banks? With interviewees indicating that bank financing is currently not a limiting factor to do deals, it is worthwhile to assess the health of the Belgian banking system. Figure 6 indicates that total loans have decreased at a rate of 4% p.a. in the 2008-2012 period, both as a result of deleveraging of the banks and less demand for loans. Profitability of the banks has been weak, fluctuating between a low of -38% ROE in 2008 and a peak of 12% in 2010. The figures support the view that the Belgian banking system will remain under strain in the next years and will likely not be in the position to assume similar high-risk exposure positions to PE-backed companies as it did pre-crisis.9

5

How to Finance Small and Middle-Market Private Equity Deals in Belgium?

FIGURE 6: T  otal loans in Belgium have decreased while profitability of the top 4 banks has been fluctuating between deeply negative to slightly positive EUR billion (total loans); % (ROE) – Belgian banks
Return on equity Total loans

500 400 300 200 100 0

451

447

456

432

20 388 10 0 -10 -20 -30 -40

2008

2009

2010

2011

2012

NOTE: Weighted average of ROE for Belfius, BNPP Fortis, KBC Groep, ING Bank Belgium SOURCE: Economist Intelligence Unit, Bankscope

Different impact across different company-sizes Several interviewees indicated how the availability of LBO financing is different across transaction-sizes. Transactions with debt tickets of EUR 10 million – EUR 75 million generally have easy access and can even obtain relatively cheap financing from the competing four main Belgian banks, especially when compared to prices prevailing elsewhere in Europe.iv Large transactions, which require debt tickets of multiple hundreds of millions, can tap nonbank sources of financing, especially as large loans and bonds are more easily syndicated across banks and investors. For example, larger companies, including Belgian PE-backed companies such as DEME (Ackermans & Van Haaren), Vandemoortele (Gimv) and Omega Pharma and Arseus (Waterland), have recently tapped the retail bond market to refinance themselves. Across the world, yield-hungry retail and institutional investors have been snapping up issuances of larger companies at record-low yields.10

iv

No specific research has been done on the availability of financing for deals that are smaller than the cut-off level to be handled by the acquisition finance/leveraged finance departments of the banks. Anecdotal evidence indicates that access to financing might in some cases be more complex in this category than it was pre-crisis, as a result of lower riskappetite from banks and increased demands for documentation and reporting. Due to competition among the main banks, pricing in this segment is often lower than for larger deals. 6

1. WHICH STATE OF THE WORLD ARE WE IN?

This leaves the segment which requires debt tickets of approximately EUR 75 million – EUR 200 million. As the current, typical exposure of Belgian banks per transaction is EUR 25 million per bank, such transactions require that either all four banks club together, a syndication is pursued and/or that other sources of financing are tapped. It is in those situations that financing can be more of a challenge, as Belgian banks are maxed out and other sources of financing might be less interested due to the relatively small investment size versus the effort required. While it should be repeated that none of the interviewees knew of a deal that did not go through solely because of lack of financing, it is in this segment that sometimes creative solutions or simply higher pricing have to be offered. Private debt placements or credit funds offering mezzanine or unitranche, can play a role in this regard as will be further detailed.

1.3. Future Private Equity Returns Will Be Lower
“While I haven’t heard many PE-funds publicly admitting it, returns seem to be going to down to 15-18% versus the historical 25%, especially on the safe, high-quality assets.” --- Banking Executive “As a banker, I have limited interest whether a deal is primary or secondary. However, in secondary deals the company has already been made more efficient and assets have often been taken out through a sale & leaseback. These are the kind of things that my credit committee does not really like to see…” --- Banking Executive

What does this mean for PE-returns? While few players in the markets are ready to publicly acknowledge it, the high prices and more limited use of leverage are expected to inevitably push PE-returns lower. An argument that is sometimes heard is that the assets which are currently being traded are higher-quality and safer assets, which therefore require a lower expected return to offset their lower risk profile. However, in order to meet absolute-return promises made to LPs, private equity funds cannot just rely on safe but low returns on high-quality assets.

7

How to Finance Small and Middle-Market Private Equity Deals in Belgium?

The expected lower PE returns seem to move in parallel with the increase in secondary and tertiary buyouts. As shown in Figure 7, based on EVCA data, sponsor-to-sponsor sales have been an important part of deal-making activity since 2007. Sponsor-to-sponsor deals are often cited to have the advantage of being “proven” and thereby lower-risk. However, many of the improvements have already been achieved by the previous investors, which typically reduces the potential for very high returns.

FIGURE 7: S  ponsor-to-sponsor secondary (or tertiary) exits constitute a large part of the deals done in Belgium in recent years, both in value and in number of deals Share of total equity invested; Share of no. of transactions, % - Belgium
% of total value exited % of total deals exited

53% 44% 33% 23% 16% 9% 0% 2005 2006 2007 2008 2009 2010 2011 2012
SOURCE: EVCA Yearbook

41%

6%

5%

9%

14%

20% 4%

15% 16%

2005 2006 2007 2008 2009 2010 2011 2012

8

2. HOW IS POST-CRISIS DEAL FINANCING DIFFERENT FROM PRE-CRISIS?

2.1.  Capital Structures and Conditions of Financing Have Changed
“Covenants are tighter, but still do-able. Prevalence of bullet loans has decreased, there are stricter senior debt/EBITDA levels, higher spreads, and more reporting requirements.” --- Private Equity Executive “Belgian bank-loans are still lower cost than foreign bank loans. However, historically the difference was bigger” --- Private Equity Executive

Both the data analysis and the interviewees confirmed that average capital structures and conditions for small and middle-market Belgian deals have become more strict. In addition to the lower level of leverage, pricing and covenants have tightened. How has the average capital structure changed? In 2005-2007, a typical small or middle-market buyout capital structure looked as following: term loans A-C, possibly supplemented with a second-lien and/or mezzanine tranche. Now, capital structures have converted to a combination of term loans A-B, no more second-liens and potential junior tranches provided by mezzanine. In addition, asset-backed refinancing has become more popular, driven by Basel-regulation which incentivizes banks to lend against secured assets. Also, vendor loans and private placement refinancings are being used more, thereby providing an alternative to secured or senior bank debt and expensive junior mezzanine. Alternatives to bank-financing will be discussed in Section 2.3. Lower pricing As Figure 8 indicates, spreads on senior debt have increased from an average level of approximately EURIBOR + 250 basis points (BPS) in 2005-2007 to EURIBOR + 400 BPS and higher in 2010-2012. However, as EURIBOR base rates were down to close to 0% in early 2013 from levels of 3.5%-4% in 2007 (see Figure 9), the real cost of borrowing has actually gone down.

9

How to Finance Small and Middle-Market Private Equity Deals in Belgium?

FIGURE 8: A  verage low-high spreads on senior debt (term loans, revolver, capex facility or similar) have increased significantly in 2010-2011 versus pre-crisis Basis points above EURIBOR (or LIBOR in selected cases) - Benelux 600 500 400 300 200 100 0 2005
SOURCE: Report data sample

375-525 175-500 225-325 200-325 150-325

2006

2007

...

2010

2011

FIGURE 9:  EURIBOR rate has dropped more than 3% between Jan-2007 and Jan-2013 1-week EURIBOR rate, % 5% 4% 3% 2% 1% 0% Jan05

Jan06

Jan07

Jan08

Jan09

Jan10

Jan11

Jan12

Jan13

SOURCE: EURIBOR-rates.eu

10

2. HOW IS POST-CRISIS DEAL FINANCING DIFFERENT FROM PRE-CRISIS?

Difference with neighboring countries It is interesting to remark that both bankers and private equity interviewees indicated that the cost of financing in Belgium, especially in the small buyout segment, is in general cheaper than in the neighboring countries. Strong competition between the banks in a slow-growing, mature market can be used by the PE houses to obtain relatively low pricing. Stricter covenants Apart from spreads, interviewees agreed that financing conditions have tightened. As Figure 10 indicates, maturities on senior debt have decreased from an average of 7 years to 6 years as a direct result of stricter Basel-regulation that incentivizes banks to lend on a shorter-term basis. Term loan C, with longer maturities, has also disappeared from capital structures. In addition, interviewees indicated that stricter negative covenants limited leverage levels (e.g. senior debt/EBITDA). Also, reporting requirements are said to have become stricter. Several interviewees indicated that this change in covenants fits into a broader convergence of Belgianmarket-specific credit agreements to international standards. This convergence thereby allows less degrees of freedom for individual credit agreements.

FIGURE 10: A  verage maturity per year and across senior debt instruments has decreased on average with 1 year No of years of maturity – Benelux 8 7
-1 -1

2007 2010-2011 7 7
-1

8 7 6 5 4 3 2 1 0

6

6

Term Loan A

Term Loan B

Revolving Credit Facility

NOTE: As Term Loan C’s are typically not being used anymore post-2010, the real maturity reduction is even higher than shown on the Figure. SOURCE: Report data sample

11

How to Finance Small and Middle-Market Private Equity Deals in Belgium?

2.2.  Who Provides Financing: Four Main Banks Dominate Again
“We are more domestic than ever. If there is not a general relationship with the company, we are likely not going to provide acquisition credit. Side-business is very important now.” --- Banking Executive “With the benefit of hindsight, would we not use again foreign banks as we did pre-crisis? I don’t think so. We would still do it, especially as the resulting problems turned out to be limited. In the current atmosphere of conservatism, everyone is forced to stay local though” --- Private Equity Executive

“I think all four big Belgian banks will remain committed to acquisition financing. The reason is clear: if you do not participate, you can forget the relationship for multiple years.” --- Banking Executive

Figure 11 makes it unmistakably clear: the four main banks have strengthened their relative position in the Belgian leveraged loan issuance market in 2010-2012 versus pre-crisis. While each of the four main Belgian banks has been faced with significant challenges on a company-wide level, the general move of banks in Europe to refocus on domestic markets has clearly also occurred in Belgium.

FIGURE 11:  Four main Belgian banks have strengthened their position Bookrunner positions per bank, % of deals in sample - Belgium
80 70 60 50 40 30 20 10 0
BNPP Fortis (before ’Fortis’) KBC Belfius (before ’Dexia’) ING

74 61 56 58 56 56 45 42

74 61 52 50 36 29 14 15 11 13 11 13 9 7 5 5 0
ABN Amro (incl. Fortis Bank NL) Rabobank

63

2005 2006 2007

2010 2011 2012

50 36

41 3230 23 14 6 13 7 0 33 33 25

45 29

41 33

27

25 14

21 13

18

28 21 25 23 22

27 16 15 0
UK Banks (e.g. RBS, Lloyds)

21

French German Banks Other (e.g. Banks (e.g. (e.g. DB, GE, Mizuho) SG, Natixis) Commerzbank)

NOTE 1: On several deals in the database, there are multiple bookrunners. NOTE 2: ThomsonOne does not list all levered loan transactions and is likely to be biased towards middle-market and large leveraged loans. In a sample of only small and middle-market loans, the domestic bank dominance would likely be even more outspoken. SOURCE: ThomsonOne leveraged loan database (excluding Bel20 or similar companies)

12

2. HOW IS POST-CRISIS DEAL FINANCING DIFFERENT FROM PRE-CRISIS?

Rise in club-deals The interviewees highlighted another important trend in the Belgian leveraged loan landscape: increased clubbing together of banks on deals. This trend is in line with the regulatory changes facing banks to limit the size of risk exposure to specific transactions. Club deals have the additional benefit that the position of the banks is strengthened by reducing the competition among lenders. Growth in asset-backed refinancing Both banks and PE executives indicated the trend to search for the maximum number of asset-backed financing opportunities in the capital structure. Asset-backed financing such as inventory-based financing and factoring is reported to be increasingly used. With the lower risk for lenders associated with asset-backed financing, the cost of this form of financing is also lower than the cost of traditional acquisition financing. The move to assetbacked refinancing is propelled by Basel III-regulation, which puts lower capital requirements on banks for asset-backed financing than for conventional cash-flow based financing. Big advantages in staying domestic? The pre-crisis years were characterized by the aggressive entry of foreign banks in the Belgian market, with as most-publicized case the Icelandic banks who sought to deploy their capital excess in 2006-2007. The interviewees indicated that relatively few problems ultimately occurred with these loans, even if several of the foreign issuers (e.g. Icelandic banks, RBS, HBOS, Commerzbank/Dresdner) had to be (partially) bailed out by their governments. The foreign banks are reported to have simply sat on their loans as they were unwilling to get them paid back at a discount. One particular problem occurred in the form of the withdrawal of revolver commitments. These cases were ultimately solved by increasing the exposure of the other arrangers. Another problem occurred in an amend-situation where the bankrupt foreign bank clashed with the other creditors as the foreign bank focused on short-term cash generation and was not willing to sweat out a potential later full recovery. Also here, the existing creditors increased their exposure to solve the situation. The consensus from the interviews among PE executives was that they are currently adhering to the current conservatism in the Belgian market, but would likely go again with foreign banks in case those would offer better conditions than the four main banks. An executive described the risk as “similar to a refinancing moment where you just have to pay a bit more interest”.

13

How to Finance Small and Middle-Market Private Equity Deals in Belgium?

2.3. Non-Bank Lending Alternatives Ramping Up?
“Mezz pricing is often too high for us. We only use it if we need to go fast and when there’s no ready availability of other debt. Typically this is when the price paid is high.” --- Private Equity Executive “Private placements seem very interesting to increase flexibility in financing. However, future has to tell whether there won’t be a maturity mismatch problem. Let’s hope first of all that the initiative does not get killed prematurely with one of the current retail or private bonds going bad.” --- Private Equity Executive

“We definitely see a surge in private placement activity, with several private bankers becoming more innovative to satisfy the yield-hunger of their customers. We have a few concerns however: is the risk/reward balance correct and how will private investors react when a company is in crisis?” --- Banking Executive

Several non-bank financing alternatives have been proclaimed as potential solutions to replace the shortfall in risk-taking by the regular bank-lenders. As indicated in Section 1.2., some of the oftencited solutions such as high-yield bonds, are typically not available for small and middle-market deals in Belgium. Several interviewees indicated that vendor loans and private debt placement refinancings are the most important alternative sources of financing for small and middle-market deal financing.v Mezzanine and unitranches offered by credit funds are used as well, but seem so far less prominent than elsewhere in Europe. Vendor loans increasingly used While vendor loans have been around for a long time, several interviewees indicated that vendor loans are increasingly being used as a financing source in Belgian small and middle-market deals. While vendor loans often share the same characteristics as mezzanine in terms of seniority and lack of liens, the cost of vendor loans is often around 6-7% versus mezzanine pricing of minimum 10% and often significantly higher. Taking into account the disconnect between buyers and sellers discussed in section 1.1., vendor loans have as important additional feature that they provide alignment of incentives between two parties.

v

An additional noteworthy initiative is the use of insurance wrappers. For example Gigarant, an insurance wrapper offered by PMV/Flemish Government, can improve the credit rating for up to 80% of SME financing. 14

2. HOW IS POST-CRISIS DEAL FINANCING DIFFERENT FROM PRE-CRISIS?

Tapping yield-hungry investors via private debt placement refinancings While issuing publicly traded investment-grade or high-yield bonds is typically restricted to large companies in need of multi-hundred million EUR debt tickets, private placements provide similar debt instruments for small and mid-size deals as well. The concept is similar, but instead of having an arranger distribute a bond to the public market, a private debt placement is non-public and typically put together through one or more intermediaries such as private banks who pool together commitments from (semi-) institutional investors. Private bank intermediaries, such as Petercam, Bank Degroof and KBC Securities, are active in the Belgian private placement market. Examples of recent private placements include FNG Group (EUR 15 million) and Vemediavi (EUR 19 million).11 Several PE interviewees indicated that they were considering refinancing portfolio companies via private placements. A question related to private placements is whether this is a temporary phenomenon where private investors currently desperate for yield are subscribing to the placements or whether this is a long-term financing source. An important concern voiced by the banks related to private debt placements is how private investors will react in crisis situations and how this will offset the existing balance between Belgian lenders and borrowers in amend & extend situations (see Section 2.4). Mezzanine and unitranche not (yet) widely used in Belgium While on a European level credit fund offerings such as mezzanine and unitranche are cited as fast-growing financing sources, the interviewees unanimously agreed that they are not yet widespread in Belgium.vii To get the context right, it should be noted that credit fund lending capacity in Europe (estimated at a couple of EUR billion) is dwarfed by bank loans outstanding (estimated at > EUR 4.5 trillion) in early 2012.12 Credit funds are therefore oriented to a subset of deals, typically where no other source of financing is readily available. A first reason for the limited use of mezzanine is related to the price: with a pricing of 10-11% (and up to 16-17% including warrants), many sponsors don’t consider mezzanine as particularly attractive, especially when average PE returns are decreasing. Another reason for the limited use of mezzanine and unitranche is the limited need: in most cases where there is a financing shortage to be filled in addition to bank financing, sponsors are able and prefer to put in more equity themselves or syndicate to another fund. Finally, Belgian-based PE executives feel that they have limited exposure to credit funds as those are mostly based and focused on Paris and London.

vi

Before IK Investments buyout in October 2012. Unitranche is an instrument with blended characteristics of a senior term loan and junior debt. Example unitranche providers include Ares, GE Capital and AXA PE. Example unitranche providers include Ares, GE Capital and AXA PE.13
vii

15

How to Finance Small and Middle-Market Private Equity Deals in Belgium?

2.4. Will Amends & Extends Remain Friendly?
“When I look around, I see the same faces which I will see in the next 1, 2 or even 5 years. This helps cooperation.” --- Banking Executive “Generally, we don’t want the keys. We feel it is not our expertise to run companies. With new players increasingly penetrating the capital structure, I feel this model might change in the future.” --- Banking Executive

“Due to the friendly relationship with banks in crisis-situations, we didn’t really need a Chapter 11-like way of restructuring so far. Now, if new lenders enter the capital structure, we might have to change legislation to avoid unnecessary liquidations” --- Private Equity Executive

The traditional way in which amend & extend situations have been dealt with in Belgian small and middle-market buyouts has been friendly: maturing loans are usually expected to be extended and a cooperative stance characterizes crisis situations where terms need to be amended. Most interviewees confirmed that they expect this cooperative stance to continue in the near future. Changes in who provides lending and new regulatory incentives for banks, might slowly start to change this equilibrium however. Context of the friendly nature of Belgian amends & extends How can it be explained that the Belgian market has been characterized by a more friendly approach towards amends & extends than most Anglosaxon markets? An important reason is the high concentration of the four large banks and relatively small number of PE funds active in the market. As the same players expect to continue to work together in the future, it is hard to act opportunistically. In the Belgian context, it is easier to come to an agreement on settlement than in Anglosaxon markets where syndication is more prevalent and the group of involved lenders is more fragmented. With the Belgian banks gaining market share recently, most of the interviewees did not expect important changes in the friendly nature of amend & extend situations. Changes on the horizon Does this mean that nothing is there to change? Probably not. A possible rise in non-bank lending alternatives makes it likely that future crisis-situations in small and middle-market deals might be harder to work out than they have been in the past. The inexperience, fragmented nature and misaligned incentives of other lenders might make it more difficult to reach an out-of-court settlement in the future. Conversations with PE-lawyers pinpointed that this might result in the need for a further move towards a complete Chapter 11-like in-court process for dealing with insolvency situations in Belgium. It should be noted that the Belgian 2009 Insolvency Act took the first steps towards the US Chapter 11-model already, but bottlenecks remain to make judicial reorganization a worthy alternative to liquidation.13

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2. HOW IS POST-CRISIS DEAL FINANCING DIFFERENT FROM PRE-CRISIS?

2.5. Wrap up: Winners & Losers
When reflecting on the current Belgian small and middle-market PE financing landscape in terms of “winners & losers”, it’s clear that few, if not no, clear winners can be identified. The winner-loser classification is made based on both a relative basis (“winning market share from your competitor”) as an absolute basis (“increasing your absolute gains”). The list of markets actors includes: the four main banks, foreign banks, private-equity funds, public and private debt placement investors, public and private-placement arrangers, CLOs, and credit funds. Possible Winner: Arrangers Regulatory pressure on the large deposit banks to minimize risk exposure combined with many institutional and retail investors hunting for yield, have the potential to establish arrangers as increasingly important players in the small and middle-market financing landscape. While several PE executives were contemplating to work together with arrangers in the near future, the market still needs to develop itself for PE-deals. Arrangers typically operate as middlemen in refinancing situations, connecting issuing companies with buyers of the bonds. The issued bonds are typically used to optimize the capital structure by replacing higher-cost financing instruments, increase capital structure flexibility and/or provide additional financing for diverse purposes such as M&A. Compared with bank debt, bonds have the advantage that they can assume different risk exposure than banks are nowadays willing and able to assume, such as unsecured junior debt tranches and/or holding-company debt. A drawback of arranged bonds, especially for small-and middle-market deals, is that PE investors cannot rely on this source of financing to close a deal, and thereby arrangers typically only operate in a refinancing context. Another drawback is that appetite of (semi-) institutional investors has historically been very much driven by market waves. Possible Winner: Credit Funds While credit funds, such as mezzanine and unitranche providers, have gained limited traction so far in Belgium, increased banking regulation has provided them with a competitive edge over banks to become opportunistic lenders of last resort in deal financing situations. While before deposit banks would be willing to assume mezzanine or other higher-risk tranches of debt, the regulatory tightening makes this less likely in the future. Arranged bonds can also not fill this void, as bonds typically cannot be relied upon to close a primary deal financing. The drawback of credit funds is that their pricing is often high, which restricts them to a niche situation. Ambivalent: Four Main Banks The four large depository banks clearly regained market share versus foreign banks in the Belgian deal financing landscape. However, while winning against the foreign banks, these banks at the same time have to accept that their lending options are increasingly being restricted by regulatory pressures. As a result of this, especially for junior tranches in capital structures, the main banks have to see arrangers (which are sometimes in-house subsidiaries of the banks, but often smaller specialized banks) and credit funds gradually establish themselves in positions that were previously dominated by them.

17

How to Finance Small and Middle-Market Private Equity Deals in Belgium?

Ambivalent: Private-Equity Funds The funds can partly look back over the recent years with a positive view: they proved that the PE-business model can weather a deep crisis, they almost all raised new funds recently and saw new debt-financing alternatives springing up, even with the foreign banks retreating. However, the promise of absolute-returns of 25%+ seems unlikely to be possible in the Belgian market where there are less deals, lower leverage available and deals are highly priced. Ambivalent: Public and Private Placement Investors With arrangers connecting both institutional and retail investors to companies in need of debt, bond investors of all sort are increasingly able to grow their position in the market. While bond issuances have existed for a long time, the strong position of banks in the past gave less room to bond investors to play in the Belgian market. However, there are some doubts whether the recent increased exposure is necessarily a positive aspect for bond investors. Time will tell whether the low yields on several of the current bond issues justify the (often) substantial risks taken. Loser: Foreign Banks With exception of the Dutch banks, the foreign banks lost significant bank-financing market share to mainly the four main Belgian banks. Also, the current presence of UK, French and German banks, as depicted in Figure 11, is almost entirely concentrated on larger issuances of leveraged loans and less to the small and middle-market deals. Loser: CLOs The recent regulatory tightening, which requires European CLOs to assume exposure to a substantial part of the CLO equity risk, had almost entirely wiped out this once important source of upper middle-market and large-LBO deal financing. With the recent surge in demand for leveraged loans and high-yield debt, accelerating in early 2013, CLOs seem to be slowly appearing again. However it is clear that the regulatory change has made CLOs more fragile creatures that very will unlikely be able to return to their previous market position.14 The impact on the Belgian small and middle-market is expected to be relatively limited as CLOs have typically focused on relatively large deals.

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3. HOW COULD THE FUTURE LOOK LIKE?

Almost all interviewees agreed that the Belgian small and mid-market PE financing market has not yet reached a new equilibrium after the turmoil of the past years. The market is likely to continue evolving and could, absent an apocalyptic meltdown, move in two broad directions: either return to the historic situation of dominant bank-lending or (continue to) move to a more balanced model of capital markets where in addition to strong bank lending, a substantial part of financing is provided by non-bank lending. Based on the interviews and market analysis, a sketch is made hereunder on how the future small and mid-market deal financing industry in Belgium could look like. In short, non-bank lending is expected to continue to establish itself more firmly in addition to bank-lending. The banks will remain at the center of financing activity, but shift partly towards agent-activities, such as arranging private placement bonds, instead of solely acting as lenders who solely assume principal investment risk. While the role of credit funds has been limited so far in Belgium, there seems to exist a niche position for them by being able to quickly close financing gaps, especially on junior tranches. Two key beliefs are required to see this future scenario happen. First, a continuation of the regulatory trend to curb risk-taking by banks, especially as this will create a possibility for other lenders to provide debt for more junior debt tranches that the banks are not able to serve. Also, as non-bank lending involves new sources of financing such as retail investors, family offices and other institutional investors, it is important to not destroy the nascent direct-investment confidence that is being built up these days. In this regard, we need to believe that no premature crash of a high-profile recent public or private debt placement occurs.

3.1. Move To a Rise in Non-Bank Financing?
Setting the context right Above description of the future assumes a move towards a more balanced model where non-bank and bank-financing are both of significant size. For example, currently in the US, approximately 75 per cent of financing is raised by non-bank lending and only 25 per cent by the banks. It is the reverse in Europe.15 However, to get the context right, it is important to remark that for small and middle-market deals in the US, banks are fully dominating PE-financing as well. In this regard, the above-mentioned scenario only assumes that non-bank financing will be established as a more significant complement to bank-financing than it currently is, not as a complete overhaul.
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How to Finance Small and Middle-Market Private Equity Deals in Belgium?

Who will perform which role? The main lenders are expected to be the following: the four main banks (Belfius, BNPP Fortis, ING, KBC) and smaller banks (e.g. Landbouwkrediet), arranging banks (e.g. Degroof, Petercam, KBC Securities,…) and credit funds (either local PE funds or specialized foreign funds). It is expected that the role of these actors will be different across deal sizes. For small deals (enterprise value < EUR 50 million), there seems little doubt that financing from the four main banks will continue to provide the vast majority of capital. In some cases, credit funds could get involved to solve a particular financing need, e.g. with a small mezzanine tranche. The use of vendor loans in some cases is expected to continue as well. For middle-market deals (enterprise value > EUR 50 million, < EUR 400 million), a split between primary deal financing and deal refinancing should be made. For primary deal financing, sponsors are expected to still finance the majority of senior/secured parts of leveraged deals through banks. Junior tranches will either be non-existent on deals or will be mostly supplied by vendor loans or by credit funds.viii There seems little potential to involve other non-bank sources of financing as those forms often cannot provide sufficient certainty on financing availability at deal closure. However, for middle-market deals, the primary acquisition financing provided by banks could increasingly become refinanced by private placements after deal closure, offering better conditions. Currently, public and private debt placements in the Belgian market occur often as opportunistic refinancing by companies, to take advantage of low-cost pricing windows. This opportunistic use of non-bank financing is expected to continue, similarly to how high-yield markets for large deals “open and close”. However, with the current regulatory push to establish non-bank financing alternatives, the private placement market in Belgium is expected to expand. As arrangers will increasingly standardize the process for family offices or other (semi-)institutional investors to subscribe to private placements, this form of financing will increasingly become a complement to bank financing, especially for junior debt tranches or deals where covenant-flexibility is desired. A key challenge for this scenario to come through will be to balance the interests of banks, who generally prefer not to sit together with non-professional bond-holders in capital structures in crisissituations. Potential for syndication Currently, when a Belgian bank provides acquisition financing, it typically puts the full exposure of the debt ticket on its balance sheet. As described in Section 2.2., there exists a strong regulatory push to minimize risk exposure of banks, including leveraged loans. This provides underpinning for the reported increase in club-deals, where risk exposure to specific deals is limited for each bank. However, club deals are only one way of risk-reduction. In case regulatory pressure would increase even more on the banks, full syndication could further reduce risk exposure for larger middle-market deals which could provide sufficient liquidity to be traded on secondary markets. Banks could hereby move from assuming principal-investment risks to becoming agents who syndicate loans. This would entail that banks only retain a small

viii

A variant on the combination of senior and junior financing could come from unitranche bond offerings provided by credit funds. Especially in cases that financing needs to close quickly and is hard to raise from banks, unitranche could prove a viable alternative. 20

3. HOW COULD THE FUTURE LOOK LIKE?

part of the leveraged loans on their books and syndicate the remainder to investors such as insurance companies, closed-ended funds and other institutionals. This scenario is likely only going to materialize in case of further regulatory tightening, as PE funds generally do not prefer to incur extra syndication costs if there is no need.

3.2. What Do We Need to Believe?
Continued trend to tighter banking regulation An important assumption of the above-described future scenario is the belief that regulatory tightening of banks in Belgium will continue. This belief is given in by what is currently observed throughout Europe. Several regulatory proposals are on the table to even further tighten banking regulation with many of these proposals adversely affecting the role of banks in PE-financing markets. For example, an important proposal in this regard is the proposed split of deposit-taking and investment banks in Germany and the UK, which would reduce leveraged lending to private equity firms. Similar proposals have been voiced in Belgium. Risk of “losing a wheel” among the recent public and private debt placements An important driver in the current development of public and private bond markets is the eagerness to assume bond risks by retail and institutional investors. In the current low interest-rate environment, many investors consider it attractive to double down on leveraged loans and bonds because of the relatively high spread versus government bonds and the limited default rate.ix This is a macroeconomic context that could change and make investing in risky fixed income less attractive over time. Even more important to let the nascent non- bank financing market in market develop is that a premature blow-up of one of the recent public or private placements in Belgium does not happen. In this regard, a crucial factor is that the non-bank financing market expands and formalizes fast, for example through the introduction of some type of ratings of private placements. Other formalization initiatives could include the support from governments to develop private placements or pooled loan funds, a proposal that was made by for example the Breedon report in the UK. Pooling loans together into bigger “bite-sizes” would be particularly helpful to attract investors for whom size, and the resulting liquidity on secondary markets, is an important investment criterion.16,17

ix

As reported by FT, April 2013 spreads on US high-yield were 466 BPS versus US treasuries versus 2007 spreads of 233 BPS.16 Default rates for US junk-rated companies fell to 2.9 % in Q1 2013, from 3.4 % in the previous three months. A similar trend occurred in Europe.17 21

AFTERWORD

You would not be reading this study without the efforts of several people who freely contributed their time to enrich this study. First among these people is Harvard Business School professor Paul A. Gompers, who first taught me several private equity finance insights during the fall of 2012, then accepted to supervise this study and finally helped focus it in ways that have made this a stronger report. I am also grateful to Harvard Business School professor Victoria Ivashina, who provided insight in US middlemarket financing. Julien Krantz from the European Private Equity & Venture Capital Association (EVCA) who kindly agreed to cooperate and provide valuable data to enrich the report. Finally, a cornerstone to put this report together were the interviews with private equity and bank executives in Belgium. In alphabetical order of the organization name, a special thanks goes out to:
n n n n n n n n n n n n n

Alexander Lecluyse (Belfius) Kris De Brabandere (Bencis) Ann Bell and Xavier Coulie (BNP Paribas Fortis) Yvan Jansen (E-Capital) Pieter Lambrecht (Ergon) Nicolas Linkens (Gilde) Alain Keppens (Gimv) Philip Wietendaele (ING) Stephanie Declercq and Marc Van Campenhout (KBC) Frederik Vandepitte (Morgan Stanley) Philip Ghekiere and Philippe Touquet (NPM) Sylvie Carpentier (Vendis, Mitiska) Frank Vlayen (Waterland)

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ENDNOTES

1 From Michael Stothard and Mary Watkins, “Banks must shed €3.4tn from balance sheets”, Financial Times, March 17, 2013 2 From Patricia Kuo and Stephen Morris, “European LBO Loans Fall Most Since 2009 as Debt Crisis Extends”, Bloomberg, April 19, 2002 3 From Michael Stothard, “Citi and Apollo in talks over Europe CLO”, Financial Times, March 12, 2013 4 From Simon Meads, “Private equity steps into European bank lending gap”, Reuters, October 10, 2012 5 From Michael Stothard, “Near-record sums flow into Europe junk funds”, Financial Times, January 21, 2013 6 From Michele Chang, “Belgium and the Netherlands: Small Countries with Big Financial Headaches”, Paper presented at the biennial conference of the European Union Studies Association, March 3-5, 2011, Boston, USA 7 From “Global Private Equity Report 2013”, Bain & Company, February 2013 8 From Wim Van De Velden, “Volkslening krijgt fiscaal gunstregime van 15 procent”, De Tijd, January 8, 2013 9 From Economist Intelligence Unit, “Belgium Banking Report”, EIU, April 2013 10 From Michael Sephiha and Wouter Vervenne, “Omega haalt moeitelaas 300 miljoen op”, De Tijd, November 30, 2012 11 “FNG haalt EUR 15 miljoen op met obligataire uitgifte”, FNV Group press release, June 2012 ; “Vemedia successfully raises 19mio€ through private placement of a subordinated bond”, Vemedia press release, March 8, 2012 12 From Anne-Sylvaine Chassany and Jesse Westbrook, “Private Equity Enters Banks’ Turf in Europe”, Bloomberg, February 8, 2012 13 From Nora Wouters and Hendrik Bossaert, “The Belgian Chapter 11 proceedings two years on”, Global Insolvency & Restructuring Review 2011/12 14 From Michael Stothard, “Citi and Apollo in talks over Europe CLO”, Financial Times, March 12, 2013 15 From Michael Stothard and Mary Watkins, “Banks must shed €3.4tn from balance sheets”, Financial Times, March 17, 2013 16 From Lex Column, “Junk bonds: music resumes”, Financial Times, April 9, 2013 17 From Vivianne Rodrigues and Stephen Foley, “Junk bonds benefit from lack of options”, Financial Times, April 9, 2013

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