Fidelity International: Why Europe’s leveraged loan market is facing transition

Opportunities persist for those investors able to be flexible in a changing environment. Camille McLeod-Salmon, portfolio manager in leveraged finance at Fidelity International, runs the rule over current market dynamics.

Camille McLeaod-Salmon

This article is sponsored by Fidelity International

With higher inflation has come higher funding costs. What impact has this had on the European syndicated loan market?

Fidelity adopted the title The Great Reset for its Q3 2022 outlook and that is quite apt. When you look at the existing stock of leveraged issuance in the market, the majority were structured when spreads and rates were lower and accordingly could support higher debt levels. The positive of leverage loans being floating rate is that investors receive higher returns when interest rates rise.

Another consequence of higher rates, however, is that fixed costs can increase, putting pressure on cashflows and debt sustainability for weaker issuers. When you look at the European leveraged loan market, post-covid, the maturity wall has been pushed out with a pick-up in 2025 and the next significant wall occurring in 2026.

Leverage loans need to be refinanced 12 months prior to maturity otherwise they are treated as current liabilities. We are already starting to see issuers approaching the market to extend their maturities, therefore we expect solutions to be achieved for the majority of those credits.

Additionally, in the current vintage there has been a trend towards structuring deals with large revolving credit facilities to pursue buy and build strategies that would allow synergy extraction similar to corporate competitors. Those larger RCFs can provide borrowers with a greater liquidity buffer to navigate the rising rate environment.

Heading into 2022, coverage ratios were starting from a comparatively healthy level providing some cushion against rising rates or lower projected forward EBITDA. Nonetheless, weaker companies will struggle. We were at a zero-rate environment in 2020 and a zero-default rate environment in 2021. That Goldilocks period simply can’t continue, and default rates have to rise towards a more normalised 3-4 percent for this year.

What’s your outlook for 2023-24? Where do you see opportunities?

An increasing number of investors are looking at their public/private exposure and thinking about private credit as a core part of their investment strategy within the traditional asset allocation mix. Looking at the challenges of rate uncertainty, floating rate solutions, which can include structured credit, leveraged loans and direct lending, can provide an effective inflation hedge as well as added diversification for ­investors.

We expect the next couple of years will present challenges as we continue on that reset path to higher rates and that has to be absorbed into the economy. Currently we are positioning up in quality, with a more defensive bias within portfolios. Direct lending, leverage loans – and subsequently structured credit, which is created from leveraged loan vehicles – have defensive characteristics because they are senior secured instruments at the top of a company’s capital structure, owned by private equity sponsors in defensive sectors such as mission-critical software, or business services which have sticky, recurring revenues, high EBITDA­ margins and consistent cashflow generation.

The average carbon intensity of the private credit markets tends to be lower than other asset classes due to the industry exposure being tilted more towards services and with less exposure to more intensive sectors such as metals and mining, energy or heavy industrials.
It therefore makes it interesting for asset allocators transitioning to lower carbon-emitting portfolios.

Do you continue to believe investors should consider ESG when investing in syndicated loans?

It should be a high priority. For us, ESG is about assessing the whole risk of a company and it forms a part of our fundamental credit analysis and allows us to price risk more effectively. As we engage with borrowers and sponsors we want to know, for example, if they understand the potential impact of changing regulation on their business or businesses they operate with, whether they are thinking about the sustainability of supply chains and are taking steps to address labour retention.

We want to allocate capital to those companies showing the best transition and the best engagement and disclosure. We think an exclusion-only based approach can be limited in bringing about change. Take a software company for example: an exclusion-only based approach would indicate that they are always ‘good’ on ESG but they may be lacking with regards to cybersecurity, employee protection and governance. By engaging, we can help facilitate change and hopefully, over time, this contributes to better value for those businesses.

As we speak to private equity firms, it is interesting to see the change that is taking place. We have seen an increase in hiring, with people brought on board to focus on ESG within portfolio companies. Sponsors have been increasingly willing to engage with us about ESG. As we move into a more complex operating environment with significant challenges such as near-shoring and the transition to net zero, that ability to engage and make sure that issues are understood is an important part of the investment process.

Do you think investors will see a greater dispersion of returns in the market this year?

We are moving from an environment where we were flooded with liquidity at very cheap rates and now, as we transition, I expect to see more dispersion as the cost of funding increases. This is turning into a credit pickers’ market. The increase in idiosyncratic risk is allowing our team to find an increasing number of alpha-generating ideas.

What is interesting for fund investors is that as credit dispersion increases, so will manager dispersion. Investment style and approach will be even more prominent as we transition into the new environment.

As operating environments become more complex, we continue to stress the importance of a forward-looking approach, instead of relying on the last set of earnings, really thinking about how the global landscape is changing and how you join the dots more effectively.

I think that’s why you need a team that’s got a multi-asset approach so you’re able to hear from equity and fixed income analysts about what’s happening on the ground to get a holistic approach that allows you to look at entire supply chains and understand what’s happening across different geographies and regions.

I think it’s a time where you should be thinking about deeper engagement between lenders, borrowers and sponsors in order to effectively navigate more challenging situations. In the absence of maintenance covenants, we focus on continuing to strengthen those engagements in these uncertain times.

How do you see conditions in the collateralised loan obligation market at the moment?

CLOs are arbitrage vehicles, where investors aim to maximise the spread between assets and the cost of funding for the vehicles. Over the last month ­triple-A spreads, the largest debt tranche for CLOs, have compressed from 215 to 165 basis points, which has helped drive the reduction in overall ­liability funding costs.

“That Goldilocks period simply can’t continue, and default rates have to rise towards a more normalised 3-4 percent for this year”

At the same time however, lower liability costs have encouraged CLO issuance, which has caused secondary leveraged loan prices to rise. At the moment there are anywhere between 55-70 CLO warehouses open, ready to come to market if the internal rate of returns makes sense, ie if secondary loan prices dislocate or if liability spreads continue to tighten, or both.

New primary loan issuance is needed to help support new CLO creation in the market. M&A has slowed, largely in our view due to a mismatch in valuation expectations between buyers and sellers. However, there is significant private equity dry powder and we anticipate that dealflow will start to pick up again in the coming quarters.

And you’re not seeing CLO structures come under pressure?

Rising liability costs coupled with a lack of new issue loans at wider spreads, made CLO arbitrage targets more difficult to achieve, which prompted a range of structural solutions to help increase equity returns. Managers ­delayed the launch of the single-B tranches, negotiated shorter non-call periods, structured deals with higher bond buckets and issued static transactions with better credit enhancement.

Lower loan prices meant the bulk of the IRRs for last years’ deals were driven by the pull to par. This made hitting return targets trickier as price movements were volatile. As an example, a modelled one-point move in loan purchase prices could have had a three-point impact on expected IRRs. During August last year loans moved four points, as a result of which return projections could move significantly even over the course of a few days.

Despite challenges the market has proved that it is not only resilient, but participants can be flexible and creative in terms of finding solutions.

Overall, where do you see opportunities in the market at the moment?

We think the new primary vintage is shaping up to be probably one of the most interesting vintages. The last time we saw conditions like these in the European leveraged loan market was in 2012 and 2013. We expect to see borrower-friendly improvements in structures with new deals pricing with higher spreads, lower leverage and improved documentation.

And would you say documentation is getting better, albeit only slowly?

The answer is yet to be revealed. So far new issuance has been focused on existing transactions via add-ons or A&Es. Some documentation changes have been material while others less so. New LBO transactions will be a true barometer. While it may be a stretch too far to expect full maintenance covenants, some of the documentation terms around value leakage, asset disposal proceeds, voting thresholds and transfer provisions are likely to receive a greater degree of challenge from lenders. In the direct lending market we see terms already moving in lenders’ favour.