S&P: Lowell And GFKL's Parent Garfunkelux Holdco 2 Outlook Revised To Neg; Rating Affirmed; Proposed Senior Notes Rated 'B+'
At the same time, we assigned a 'B+' issue rating and recovery rating of '3' to the proposed €230 million senior secured floating rate notes issued by Garfunkelux Holdco 3 S. A. (Garfunkelux 3). The rating on the proposed notes is subject to our review of the notes' final documentation.
We also affirmed the 'B+' issue rating and recovery rating of '3' on the existing €365 million and ?565 million senior secured notes. We affirmed the 'BB' issue rating and recovery rating of '1' on the €200 million revolving credit facility (RCF) co-issued by Garfunkel Holding GmbH and Simon Bidco Ltd. We also affirmed the 'B-' issue rating and recovery rating of '6' on the ?230 million senior unsecured notes issued by Garfunkelux 2.
Garfunkelux 2 announced on Sept. 12 that Garfunkelux 3 intends to issue €230 million floating rate notes. We understand that the proceeds will be used to refinance a €230 million bridge facility--which financed a corporate acquisition--and pay related fees and expenses. The acquisition is that of Germany-based third-party debt collections company Tesch Inkasso Group (Tesch), which the group announced on Aug. 12, 2016. The transaction has been agreed and the closing is subject to certain regulatory approvals.
Garfunkelux 2 is an intermediate holding company, majority owned by private equity firm Permira. The holding company consolidates Garfunkelux Holdco 3 S. A., special-purpose entities Garfunkel Holding GmbH and Simon Bidco Ltd., primary operating companies GFKL and Lowell, and all of the operating subsidiaries and companies that form the group. The ratings reflect our view of the combined entity consolidated under Garfunkelux 2, including the acquisition of Tesch. We do not perceive any material barriers to cash flows within the group or any significant issues regarding fungibility of capital between the parent company, debt-issuing holding companies, or the key subsidiaries.
We believe that the debt-financed acquisition of Tesch signals a loosening of financial policy relative to our previous expectations and increases risks relating to operational integration. This is accentuated by the ongoing integration of Lowell and GFKL following the recent merger in October 2015--although we recognize the good progress made to date. We believe that the acquisition of Tesch shortly after a transformational merger represents a potential increase in the group's overall risk appetite, which could lead to an extended weakening of credit metrics, particularly if increased operational risks lead to slower cash flow generation than our base-case scenario assumes. The negative outlook signals a one-in-three chance that we could lower the ratings if the group's growth in total collections and third-party fee income is insufficient to reduce the group's leverage over the next 12 months.
Our existing financial risk profile assessment reflects our expectation of the combined entity's following core ratios:Gross debt to S&P Global Ratings-adjusted EBITDA between 4x-5x;Funds from operations to gross debt between 12%-20%; andAdjusted EBITDA to interest expense between 3x-6x. Adjusted EBITDA is gross of portfolio amortization (a noncash item).
Our base-case scenario assumes that the acquisition will lead to metrics at the weaker end of these ranges at the point of transaction closing. This reflects the debt-financed nature of the acquisition. However, we believe that the continued integration of Lowell and GFKL, plus the full-year earnings of Tesch, will likely lead to credit metrics more consistent with the existing assessment by year-end 2017. Our base-case scenario for improving cash flow generation is predicated on the group achieving:Continued growth in gross collections and its backbook of debt portfolios;Growth in alternative avenues for revenue generation following its focus on generating a larger proportion of third-party servicing income; and Strengthening in the customer footprint, given the limited overlap between operating entities' customer relationships. Our 'b+' group credit profile (GCP) for the combined entity already incorporates a downward adjustment of one notch under our negative comparable rating analysis modifier. We apply this negative adjustment based on our view that, among other things, there is some uncertainty with regards to the group's future financial policy under its relatively new ownership structure. While we consider the acquisition of Tesch to be manageable, we believe that the downward adjustment remains relevant at this time. We consider that the debt-financed acquisition shortly after the transformational merger reinforces our view that future financial policy of the group currently remains unclear.
Our business risk profile assessment remains constrained by the regulatory and operational risks that credit management services companies' face, and our view that the overall execution of the group's strategy is relatively immature given its recent formation. However, we continue to view the group as one of the largest credit management businesses operating across two large European markets. We believe that the group benefits from its scale and diversification, particularly its presence across a number of asset classes, and its growing proportion of revenue from third-party servicing income. Given its modest size, Tesch is complementary to the group's business risk profile, in our view, as opposed to transformational. We believe that the acquisition has the potential to enhance the group's market position in the German credit management services sector. It also provides the group with access to expertise in new asset classes, such as e-commerce and utilities debt.
The negative outlook indicates the possibility of a downgrade if, after the acquisition, growth in total collections and third-party servicing income is insufficient to improve its post-transaction leverage profile over the next 12 to 18 months. The acquisition of Tesch has led to a reduction in the group's headroom under its financial risk profile. We believe that there are risks associated with operational integration, which could potentially lead to underperformance and an extended weakening of its creditworthiness. However, our base-case scenario assumes that credit metrics will improve by year-end 2017, after an initial weakening on completion of the transaction. This is predicated on continued growth in the group's earnings capacity and an absence of material further acquisitions.
We could lower the ratings if we no longer expect that the group will improve its credit metrics over the next 12 to 18 months after the transaction. We could revise our forward-looking financial risk profile assessment downward if we expect:Gross debt to adjusted EBITDA above 5x;Funds from operations to gross debt below 12%; orAdjusted EBITDA to interest expense below 3x. Such a scenario could unfold if integration risks lead to a material unanticipated rise in costs or a lowering of the group's earnings capacity below our current expectations. It could also occur if we saw further signs of an aggressive financial policy, for example the group raising additional debt to fund another material acquisition.
We could revise the outlook back to stable if we saw evidence of the successful integration of Tesch that would enable to group to start improving its post-transaction leverage profile in line with our expectations. Specifically, if we believed the following ratios would remain firmly and sustainably within the given ranges:Gross debt to adjusted EBITDA between 4x-5x;Funds from operations to gross debt between 12%-20%; andAdjusted EBITDA to interest expense between 3x-6x. Diminishing integration risks associated with the recent merger and acquisition activity and evidence that Permira's strategy as a financial sponsor will not hinder Garfunkelux 2's debt-servicing capabilities would also support a stable outlook.