Banner year for US leveraged loans, but structural challenges ahead

Leverage is creeping up in large-cap leverage buyouts, riskier credits are being issued and prospects for strong recoveries are dwindling.

While the US leveraged loan market hit a new high in 2017, eclipsing the previous record in 2013, the thrill of a robust market is sowing seeds for a poor harvest when a credit drought comes.

Last year, the leveraged loan market saw $648 billion in new issuance, partially driven by a wave of refinancings, making up the plurality of deals issued in the first four months of the year, according to a report from S&P Global Ratings. That total issuance easily beat 2016’s $482 billion and the previous peak of $607 billion in 2013.

Beneath the flood of new leveraged loans, however, were data showing a rise in the issuance of riskier credits and a likely decline in recoveries, which taken with PDI survey data, doesn’t necessarily bode well for the asset class.

Of the total B- and BB-rated debt issuances, a larger portion of B-rated securities than BB-rated securities were issued in 2017, and while the percentage of the former was similar to that of 2014, total issuance in dollars last year exceeded the total posted three years ago.

“Coming out of the [global financial] crisis there was some level of conservatism and caution, if you will, in terms of the credits [investors] wanted to pick up and that has changed since,” S&P senior director Ramki Muthukrishnan said.

Similarly, the chances creditors will see a palatable recovery in a bankruptcy or restructuring scenario are declining, according to S&P data. Of the total first-lien loans issued each quarter in 2017, at least 40 percent of them had expected recoveries of between 50-70 percent, up significantly from previous years.

“We see an increased issuance of senior secured loans, with reduced subordination for them in the debt structure,” Muthukrishnan said, leaving less cushion for senior lenders. Evaluating the impact of lack of lender protections in covenant-lite deals and how it affects recoveries is harder in the absence of meaningful empirical evidence, he said.

Hanna Zhang, an associate director, explained that the very nature of covenant-lite deals takes away the opportunity for lenders to reprice risk because the lenders cannot step in when covenants are breached to renegotiate the credit agreement.

“Given all this, much about the current state of the leveraged loan market still raises warning flags, particularly the decline in new loan ratings and recovery prospects on first-lien secured debt,” the report read.

Our recent survey of limited partners conducted across the alternative asset classes – private equity, private real estate, infrastructure and private debt – whether each performed above, at or below expectations.

Private debt came in last when asked if their private debt portfolio had posted better-than-expected returns (23 percent). Private real estate (35.92 percent), private equity (32.37 percent) and infrastructure (28.92 percent) each posted much better numbers on the same question.

A full 83 percent said private credit performed at or above expectations, but if investors are looking at alternatives for out-sized returns, one may be able to make a stronger case for the three other alternative asset strategies as opposed to private debt.

In another sign of the times, private equity auctions are increasingly becoming much more favourable to those firms vying for a given portfolio company, Béla Szigethy, co-chief executive of The Riverside Company, told Private Debt Investor sister publication Private Equity International.

“Today the process as a buyer is brutal and as a seller it’s beautiful,” he said, explaining that the deal process five years ago took about six months but that has compressed to 60 days. Naturally, that allows less time for due diligence, and of course private equity firms now need quicker financings.

Szigethy noted the biggest reduction came in the time between the management presentation and when the deal closes.