Alchemy has been watching the market now for four years. Through its ownership of Alcentra, the largest CLO manager in Europe, Alchemy was able to track the exponential growth and structural changes in the European leveraged debt markets. The European leveraged noninvestment grade market has grown from about €50 billion in 1998 to exceed €600 billion in size, three quarters of which is leveraged loans, with the remainder comprising high yield bonds and mezzanine finance.
This explosive growth has been driven by CLOs, which dominate the leveraged loan markets today, taking up to 70 percent of new issues. From fewer than 10 CLO managers in 2000, there are now in excess of 130 in Europe alone, each managing multiple CLOs. The growth has driven almost insatiable demand for leveraged product, which in turn has pushed leverage ratios to eight-year highs in Europe, well over 6x on average in the first quarter of 2006.
The credit quality of new issues is deteriorating; 38 percent of high yield bonds issued in 2005 were CCC rated and historical data suggests that a third of these bonds will default within two years and 43 percent within three years. While default rates remain low, this is because the market has grown so rapidly and we have yet to see the seasoning effect on these new capital structures.
Over 75 percent of the European market is PE-sponsored LBOs. Typically these debt structures don't encounter stress for the first year or so. It is only in years two and three that cash becomes tighter, covenants begin to bite and the issuer is required to start repaying some of its senior debt. This secular trend is entirely predictable and does not rely on any external shock or material economic downturn – it will drive European default rates back towards long-term historical averages of around 3 percent.
The core strategy of the fund is a take an influential stake (between 10 to 20 percent) of the fulcrum securities of distressed companies, typically holding our investments for between one and three years. We call this a control strategy, although we will generally own less than 51 percent of the equity of a company. Control to a private equity investor generally means outright control (100 percent) or at a minimum more than 51 percent, whereas in distressed debt, we aim to control a restructuring with a small number of other investors who together will own more than 51 percent.
We see very strong growth for European distressed debt on the back of the dramatic growth in the primary market for leveraged debt. Distressed debt investors in Europe simply haven't had this opportunity before. We now have a ready-made market of what are often good businesses with stable cash flows and/or good growth characteristics but with an excessive debt load. In Europe we are pre-cycle, whereas in the US it is a more mature and cyclical business.
I'm not predicting a bursting of the bubble, although the market has some bubble-like characteristics, notably the debt multiples and the ability for the market to price almost any risk, however extreme. There will be an inevitable correction and PE firms will have to prepare for a time when there is less liquidity in the debt markets and less appetite for risk. This will drive down purchase price multiples or require that PE firms put more equity into their buyouts – either way, something will have to give.
We regard the dynamic legislative environment as an opportunity rather than restriction to investing our capital. It adds complexity and uncertainty but with the right approach we think this will drive higher returns for our business. Certainly the already complex and varied insolvency codes across Europe provide an opportunity for smart investors to outperform.