OREANDA-NEWS. December 17, 2015. In a report published today, Fitch Ratings says that the current economic environment in Europe has reduced financial sponsors' confidence in the ability of speculative-grade borrowers to sustain higher leverage in secondary buy-outs (SBO) and dividend-recapitalisations (together "recycled" deals) compared with the pre-crisis period of similar capital market liquidity and optimism from 2005 to 2007.

Benign credit conditions since 2013 have been fuelled by strong demand from central bank-supported "search for yield" against limited supply. Financial leverage has returned close to pre-crisis norm of about six times operating profit in many cases, and investors have been tempting issuers with weaker lender protection. However, contrasting with the pre-2007 period are the prevailing weak aggregate demand conditions in Europe that translate into lower volumes and less pricing power. Given this backdrop, financial sponsors have generally assumed more conservative revenue growth, profit margin expansion and deleveraging profiles in SBOs and dividend-recaps in the period from 2013 to 2015 than in such transactions completed before the financial crisis of 2008.

In the current high public equity and trade buyer valuation environment, indicating enterprise value (EV) multiples back to 2007 levels, financial sponsors are likely to continue selling their portfolio companies as they find the value proposition in buying primary assets and recycling deals much less attractive than before 2007. Even when attracted to target assets in vendor auctions, sponsors have lost out to trade buyers with cost savings advantage and lower medium-term return requirements.

However, some European sponsors have addressed the lack of deal flow and coped with the pressure to invest the funds they have raised by adopting the same tactics as trade buyers. Small to mid-sized bolt-on acquisitions or occasionally, larger transformational M&A activity undertaken by private-equity sponsors' portfolio companies has gained momentum in 2015. The combination of Germany-based laboratories group synlab Holding GmbH and that of France-based Labco SA by private equity firm Cinven is one example of this trend. From a sponsor's perspective, M&A represents significant opportunity to enhance returns through scale, cost savings and synergies given the currently low levels of economic growth.

In the new report, Fitch compares the business plan assumptions presented by financial sponsors at the time of a recycled transaction (SBO or dividend recap) with the ones outlined in the initial transaction. The analysis has been conducted on deals concluded pre- and post-crisis. The report, 'Recycled LBOs: A Tale of Two Cycles' is available at www.fitchratings.com or by clicking the link above.