Most European leveraged finance market participants predicted 2008 would usher in more conservative transactions and protection for lenders. Standard & Poor's credit analysts TaronWade and PaulWatters find emerging evidence for this

It has been a rocky year for the European leveraged finance market since the mid-year liquidity crunch in 2007. Some investors ceased lending altogether, such as collateralised loan obligation funds, while banks stepped in as the main providers of liquidity. The market was growing explosively before the crunch, but over the past year it has reverted to a state similar to that of 2003 when it was dominated by banks and consisted of mostly smaller mid-market transactions.

One year on from the onset of the liquidity crunch and the market is slowly adopting more conservative structures to meet investor demand. Ratings and credit estimates assigned to leveraged loans in 2008 reflect this trend: the proportion of B+ and BBcredits is higher in 2008 than in 2007, while the proportion of Bcredits is lower (see chart right).

The absence of recapitalisations is another sign of a less-aggressive borrowing market. Private equity sponsors tend to use recaps as a way to refinance the debt of portfolio companies and pay themselves a dividend. Inde ed, be for e the liquidity crisis, recaps proliferated widely but no recaps were completed in the first half of 2008, according to data from Standard & Poor's Leveraged Commentary & Data (LCD).

Banks became the dominant lenders in the market when most institutional investors stopped lending after the credit crunch. Now, arrangers may be tailoring structures more conservatively to appeal to banks because they typically are more credit disciplined than institutional investors and hedge funds. One example of this is the fall in senior debt multiples versus total debt multiples, reflecting the fact that banks typically hold senior secured debt. In the first half of 2008, the average senior debt multiple was 4.2x EBITDA, which is close to the 2005 average of 4.3x. In 2007, senior leverage peaked at 4.7x EBITDA, according to LCD. However, some deal features remain surprisingly aggressive. For instance, total debt multiples have not fallen as much as senior leverage. Surprisingly, total debt remains higher than 2006 average levels, when the leveraged finance market was already aggressive. According to LCD, average total leverage in the first half of 2008 was 5.48x EBITDA, compared with 5.52x in 2007 and 5.43x in 2006. The last time the average total debt multiple fell below 5x was in 2004, when it was 4.54x EBITDA.

Other deal features also remain aggressive. For example, the average EBITDA-to-cash interest ratio was 2.5x for the first half of this year, lower than 2.7x in 2007 and well below 4.0x in 2003 when structures were the most conservative since LCD began tracking the European market. This is consistent with EBITDA to senior interest, EBITDA minus maintenance capital expenditure to cash interest, and EBITDA minus capital expenditure to cash interest – three ratios that have also declined since 2003.

Generally, thin credit metrics mean that companies have less of a cash cushion if market conditions change or additional capital needs to be invested in the business, resulting in a greater risk of default. Cash cover, however, is a difficult multiple to increase in a macro-economic environment where spread margins are increasing and base rates are rising.

Protection for lenders on new deals, such as larger cash interest coverage ratios and significantly lower debt multiples, may not improve until the default rate in Europe starts to climb

There were no BB or BB+ ratings or credit estimates for deals completed in 2008. Indeed, the ratio of B credits relative to other rating/estimate categories has continued to climb. In the first half of 2008, 58 percent of transactions were rated (or assigned credit estimates of) B, compared with 51 percent in 2007 and 40 percent of all ratings/estimates outstanding at yearend 2007 (see chart right).

However, continuing concentration of credit risk is not new. In 2007, new transactions completed had a much narrower distribution of credit risk compared with outstanding rated credits and companies assigned credit estimates at the end of that year. It has now become increasingly rare to see credit risk in the BB range for new transactions.

Meanwhile, flexibility in existing structures is keeping default rates low. Historically low default rates are one of the reasons why deals in the leveraged finance market have not become more conservative. Often there is a lag effect in capital markets where difficult economic conditions take time to affect companies' cash flows. This has been amplified by the fact that so many highly leveraged companies refinanced their capital structures ahead of the 2007 credit crunch . Fundamental problems and resultant cash flow difficulties are being buffered by ample liquidity and a lack of effective loan covenants that would allow lenders to step in and demand better terms or repayment.

This is most likely why default rates have not yet climbed steeply despite the worsening economic conditions we have seen throughout 2008. Protection for lenders on new deals, such as larger cash interest coverage ratios and significantly lower debt multiples, may not improve until the default rate in Europe starts to climb, forcing lenders – particularly banks – to face facts and demand better terms.

At the same time, investors are finding comfort in rising equity contributions from private equity sponsors. Average equity percentages have risen to 45 percent in the second quarter of 2008, from 24 percent in the first quarter of 2007. However, even with larger equity contributions, reducing leverage remains difficult because purchase price multiples for acquisitions have continued to climb. For the first half of 2008, the average purchase price multiple of 10.6x is nearly a full turn higher than 9.7x in 2007 and almost two turns higher than the 8.8x seen in 2006, according to LCD. Asset prices still have some way to fall before purchasing a company with significantly less leverage makes sense for private equity sponsors.

Importantly, the European leveraged finance market is made up of a wide variety of transactions in different industries and regions that can all have diverse terms. Averages are dictated by highs and lows and are therefore heavily influenced by this variety. Furthermore, because some of the transactions being syndicated in 2008 were structured and underwritten before the liquidity crunch, the lag effect can shape deal credit statistics as well as structures and documentation.