In light of recent reports released to the market, a lender in the leveraged loan market would be forgiven for indulging in some cautious optimism. New-issuance in July aggregated to €9.5 billion - a 13-month high. The year-to-date leveraged buy-out volume of €10 billion (38 deals) compares favourably with the €2.2 billion of volume (13 deals) for the same period in 2009. Against this backdrop, however, lenders should consider the recently released statistics from the Insolvency Service, and other economic data, which suggest that the economic outlook remains uncertain. This is especially relevant to lenders in the leveraged space, because macroeconomic conditions can quickly become microeconomic and can detrimentally alter the credit position of borrowers trying to service significant debt burdens.
Leveraged market round up and Insolvency Statistics
Standard & Poor's reported at the beginning of this week1 that the European leveraged finance market had reached a 13-month peak in July. Eleven transactions were launched into primary syndication during that month: the greatest monthly amount of primary activity since the Lehman bankruptcy in September 2008.
Drill down into the detail, however, and the picture becomes less clear. Of the €9.5 billion of new-issuance, only €1.9 billion came from sponsor activity; €2.7 billion related to non-LBO transactions and the remainder came from high-yield bonds.
Insolvency Statistics for the second quarter of 20102 reported that, although company liquidations in that period were down by 19.1% year-on-year, they were up 0.5% from the first quarter of 2010. That is the first quarterly increase in liquidations since their peak at the end of the second quarter of 2009. Administrations decreased over the same period by 0.77% on the previous quarter, but company voluntary arrangements increased by 13.7%, to a peak of 232.
Naturally, insolvency data lags behind the state of the economy. Nevertheless, these figures, when read together with the recently advised drop in GDP3, the reported dip in housing prices, and the demand-side pressures resulting from the Government's fiscal tightening measures, together with the supply-side pressures that are likely to result from the eventual tightening of monetary policy, should not be taken with a pinch of salt. Indeed, the Bank of England has recently warned that the UK economy faces a "choppy recovery" over the next two years, and lowered its economic growth forecast. The Bank said inflation would stay higher for longer than previously forecast, and now expects the economy to grow by less than 3% in 2011, down from its previous forecast of nearer 3.5%. Not surprisingly, Standard & Poor's study of leveraged buyout companies published yesterday4 recognises that "the amount of free cash flow that speculative-grade companies can generate will depend on the extent of the economic recovery in Europe."
An easing of economic pressure on credits is not a foregone conclusion. In the words of the Governor of the Bank of England, Mervyn King, it will be "several years" before the economy adjusts "back to anything we can call remotely normal". In light of this, lenders should continue to stay close to their borrowers and be vigilant in reviewing their loan documentation. Financial covenants may provide an early warning of financial distress and lenders should thoroughly review the financial statements provided by their borrowers. In an era where complex financial arrangements are the norm, with large and diverse syndicates of lenders, covenant resets and consensual restructurings can prove to be difficult, time consuming and costly. When action is taken early, options such as easing covenants through a senior secured bond issue can be explored and the possibilities and opportunities available for reaching a consensual agreement between a borrower and its creditors are much wider.