The signs for the leveraged finance market in 2011 are mixed. Questions remain as to whether this year will see a fresh spate of restructurings and/or continued growth in primary issuance. Whilst data compiled by Fitch Ratings has shown that European PE backed company default rates slowed in 2010 (and premier league spending during the January transfer window topped £225 million compared with £30 million last year), the primary leveraged finance market has started slowly this year.
The European leveraged finance market improved during 2010 with a trend away from small club deals to larger and widely syndicated deals signalling a return in market confidence. Oversubscriptions have been reported on recent deals such as Vue Entertainment, Britax, Picard Surgeles and Convatec showing a healthy appetite for well structured and priced LBO deals. However the leveraged finance market still remains depressed compared with historical levels. There are a number of recurring themes and factors that will continue to inform the debate as to what the year holds in store and impact on how the year will unfold.
Macro-economic conditions remain on a knife edge. Austerity measures being implemented by a number of European governments may, at least in the short term, lead to reduced consumer spending and unemployment. The UK economy shrank by 0.5% in the fourth quarter of 2010 and fears of creeping inflation and therefore potential interest rate rises could stifle the prospects of growth. The well documented and continuing sovereign crises in Portugal, Ireland, Italy, Greece and Spain may well trigger difficulties for leveraged credits with high dependency on the economies of those countries. For example lenders to the Greek casino group Regency Entertainment are already anticipating covenant breaches. Other leveraged credits in those countries and elsewhere may find that their covenants come under pressure as required levels become tighter and underlying performance remains, at best, flat. Some believe that there have not been as many LBO restructurings as might have been expected given the parlous state of the world economy in recent years, so we may see a correction of that.
The European high yield market performed strongly in 2010. Analysts estimate that 2011 will see around EUR 45bn high yield issuance in Europe. Much of the issuance in 2010 was used to refinance impending maturities and many market participants expect this to continue. However there has been a rise in the number of LBOs where “senior secured” high-yield bonds have provided all of the term debt and the loan market a working capital facility. Loan participants are becoming more comfortable with this structure where the bonds share in the same security and guarantee package and rank pari passu with the loans (albeit that the working capital line is afforded “super senior” status in a default scenario).
Due to the increased liquidity in the high-yield bond market the headline cost is very competitive when compared with the loan market (and may well become more so with the advent of additional costs that banks may pass on in relation to Basel III – see below).
With all of that said however, the high yield bond market is notoriously fragile and does have a propensity to close very suddenly.
Many CLOs are still in their re-investment periods and many will continue to run for the next year or two. This fuels loan market capacity since CLO managers are incentivized to reinvest any repayments or prepayments they receive due to their cheap cost of funds relative to the margins available on today’s loans. This will continue to be the case in the near term particularly if high yield bonds continue to refinance existing CLO debt holdings. However, some reinvestment periods do look set to close during 2011 and it is estimated that around 70% of CLOs’ reinvestment periods will end before 2014. If CLO supply does dry up and new CLO funds (as it would appear likely) cannot fill the void this could impact primary LBO activity and hinder refinancing/amend and extend efforts.
A number of credits have already refinanced/cleaned up their capital structure, in a lot of cases, by tapping the bond market. Whilst refinancing/maturity extension does still remain a focus for many borrowers some companies may also postpone refinancing either due to the cost of doing so (since loan financing will now be on average around twice as expensive as the loan financing it replaces) or because better credits hoover up what supply there is. In any event 2011 is unlikely to be a pinch point for maturity triggered restructurings since the bulk of the refinancing cliff is unlikely to hit until 2013/14.
Although full implementation is a way off, now that the final text of the Basel III package of capital and liquidity reforms has been issued, it seems likely that prudent banks will now begin to observe how their activities would be regarded under Basel III. For many banks this will begin to affect behaviour now so that banks do not need implement all changes that they need to make all in one hit and from a standing start. Whilst the full effect on the loan and bank market is still to be seen as the detail is digested and considered, there are already a number of effects that can be postulated:
- Increased capital and liquidity requirements and restriction on overall leverage may well result in higher costs to the banks and therefore for borrowers
- Increased risk weighting for exposure to financial institutions may increase appetite to lend to corporates instead but at the same time may restrict banks that rely heavily on the interbank market for funding
- The imposition of a leverage ratio (i.e. an overall cap on capital: total assets) may mean an overall reduction on bank funded liquidity in the market. Since the assets in the ratio calculation receive no risk weighting, this may also mean that there is an increased demand for leveraged, high yielding credits to generate a higher return on a bank’s smaller asset base
- The liquidity coverage ratio requires that banks have a sufficient pool of liquid assets to cover potential cash outflows over a 30 day period. Banks would therefore need to have the entirety of any revolving credit facility commitments covered by liquid assets. This may well become relevant to revolving credit facilities proposed from now on since revolving credit facilities entered into with the customary 6 year availability period will still theoretically be in place in 2015 when it is projected that banks will have to be compliant with the liquidity coverage ratio
- The net stable funding ratio (which effectively requires long term assets to be matched by long term funding) may mean that banks are less willing to commit to the long term 6 year maturity leveraged finance loans (although in theory for loans granted this year even if they remained on their books until maturity they would mature prior to 2018 when the net stable funding ratio is due to be implemented)
- Bonds are regarded as liquid assets for the purposes of the net stable funding ratio so they are not required to be match funded (whereas loans are) meaning that perhaps banks will have more incentive to recommend to their clients that they issue bonds rather than loans
Those new deals that do get done will remain subject to the greater scrutiny that has characterized the market in the last couple of years. As a result of this secondary/ tertiary buyouts have been more readily “bankable” than new credits coming to market. Higher yields will still be required to get deals done with margins still up around 4.50-5.00% with OIDs and LIBOR/EURIBOR floors likely to remain a feature in the market.
Despite healthy competition for assets as a result of the “dry powder” currently available, sponsors must also be analysing potential acquisitions more closely. Factors such as (i) more risk averse lenders; (ii) lenders requiring more “skin in the game” so that sponsors take less risks from a strategy/operational perspective; (iii) less debt available generally; and (iv) the greater cost of funds putting pressure on target debt capacity, all mean that sponsors need to write greater equity cheques and therefore need to have a more compelling equity story to justify investments.