European leveraged finance: Five key developments

Why determining appropriate leverage levels is challenging, the current crisis is not quite like the GFC, and direct lenders are preparing for a busy period.

As with so much else, Europe’s leveraged finance market was initially hit hard by the covid-19 outbreak. Over the last month or so, however, it has shown signs of flickering back to life as adjustments to the new normal start to be made. Here are five findings from conversations with market sources.

The market is on pause, but not dead

It’s hard to believe things can change so fast. In the first two months of the year, the high-yield bond and leveraged loan markets in Europe had got off to a flying start with issuance aplenty. Then, in March, the coronavirus came along and all activity was temporarily frozen. Following the initial shock, and amid strong government support, well-liked and experienced issuers have successfully raised new money in the high-yield market. However, a large number of suspended leveraged buyout financings, near the lower end of the ratings spectrum, are still waiting for syndication. Although there is some optimism they will be sold in the coming months, pricing will be a major issue.

In some ways, things are better than during the GFC

Pretty much any corner of the investment universe is asking: “Is this another 2008?” According to the European leveraged finance market, the answer is “no” – and in a good way. Many feel that, since the global financial crisis, banks have become more disciplined in their underwriting. There is also a feeling that more sensible loans-to-value ratios will stand the market in good stead. Although deals have been highly leveraged in recent years, the proportion of equity has typically been 50 percent or more – compared with 25-30 percent pre-GFC.

A lack of visibility – until after June

Last 12 months trading is a key metric in leveraged finance, with historical performance used as an indicator of how much leverage a business can reasonably sustain. Covid-19 only began to make an impact on revenues in the latter end of the first quarter, and the second quarter will therefore provide a more realistic picture on which to base future leverage judgements. It is worth noting that businesses in some favoured sectors – such as technology, healthcare and stable infrastructure – are still able to access finance as cheaply and easily as they were before the outbreak began.

An opportunity for direct lenders

Although banks are willing to underwrite attractive deals, competition has emerged from direct lenders at the smaller end of the market. These are times of heightened sensitivity around public disclosure of information, and that plays into the hands of private markets – even though financing from the latter tends to be more expensive and to have covenants attached. For direct lenders, the opportunity to access good yield from high quality businesses may be a fleeting one if a coronavirus vaccine comes along reasonably soon. In a bear case of long recession and no vaccine, the quality and sustainability of the assets will be crucial, given what may become long hold periods.

Here comes “covenant heavy”? Don’t hold your breath

Some think the time has come to turn the tables table on covenant-lite deals. But while that may perhaps be true in the private debt mid-market, there are few bold predictions of an end to the trend in leveraged finance. But while covenant-lite is tipped to stay, some changes are afoot. Notably, deal documentation and reporting/transparency are expected to move firmly in lenders’ favour.

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