Leveraged Finance: A tale of two markets

Leveraged finance bankers on either side of the Atlantic are feeling optimistic about 2013: yield-hungry investors, transaction-hungry sponsors and a more diverse mix of funding scenarios makes for a bigger – and better – picture. Is it for real?  

Parts of the leveraged finance markets have started the year with such a spring in their step that Chuck Prince might be tempted out of retirement to reach for his dancing shoes.

As chief executive of Citigroup in 2007, it was Prince who memorably said his bank was “still dancing” in the leveraged finance markets just as the growing sub-prime crisis recalibrated everyone’s idea of what risk meant and why leveraged lending was a not-so-popular tune. Even now, more than five years later, many banks in Europe are still slashing risk-weighted assets and shrinking their balance sheets.

Today, this ‘great deleveraging’ has reached a pivotal moment because, after years of risk aversion, investors have returned to risk-on mode. A combination of low interest rates following stimulative actions by central banks, signs of an economic recovery in the US, and a belief that the worst of the European sovereign debt crisis may be over, has spurred investors to search for yield. And there are a growing number of transactions where debt – and lots of it – is a vital ingredient.

Yannick Perreve, a managing director in leverage finance capital markets at Citigroup, reports: “The leverage finance market is on fire at the moment. Investors are cash rich from the various actions by central banks. The problem is that until now there has been a lack of supply. The M&A pipeline is however building.”

That supply, it seems, has finally arrived. On a single day in February, US computer giant Dell announced a $24.4 billion take-private, while Liberty Global unveiled an agreed $23.3 billion takeover of Virgin Media in deal sizes not seen since before the crisis. In truth, neither deal adopts a classic buyout structure, but they provide an insight into the changing dynamic in the global leveraged finance market and will provide important test cases for gauging the true extent of investor appetite. Meanwhile, two LBO deals also in February from Cerved and DuPont saw such strong demand that the timing of Cerved was brought forward while Dupont was re-worked to reduce the overall cost of financing.

The search for higher returns had already helped push leveraged finance volumes to near record highs in 2012, when global leveraged finance volume totaled $1.67 trillion, above the $1.38 trillion reached in 2011, and the highest annual volume since 2007, when $2 trillion of deals priced, according to data provider Dealogic.

Within leveraged finance, global high yield bond issuance reached a record $424 billion in 2012, a 36 percent increase on 2011, and beating the previous record of $351.2 billion set in 2010. Global leveraged loan volume rose 17 percent to $1.25 trillion in 2012, the third highest annual total on record.

But dig a little deeper and there is a stark difference between the US and European markets. US dollar-denominated high yield bond issuance accounted for 86 percent of global volume, the highest proportion since 2008, while Euro-denominated issuance accounted for just nine percent of the global total, the lowest share since the crisis.

The picture is the same in leveraged loans, where Dealogic data reveals that US volumes increased to $880 billion while in Europe, leveraged loans slid 3 percent to $176.6 billion compared with $181.2 billion in 2011.

“As far as leveraged loans are concerned, it’s a tale of two markets at the moment,” explains Steven Oh, co-head of leveraged loans and global head of fixed income at PineBridge Investments in New York. “ Last year, demand in the US picked up following a resurgence in new CLO issuance during the second half of the year; in addition there were considerable institutional and retail inflows. Meanwhile In Europe, the loan market shrank as supply shifted to the high yield markets.”

Towards CLO-sure 

Bankers estimate that during 2012, around $55 billion of new CLOs were created in the US. By contrast, in Europe, the CLO market continues to stutter as funds created during the boom years of 2005 to 2007 are hitting the end of their re-investment periods. According to research from Standard & Poor’s, in 2011 existing CLO re-investment capacity in Europe stood at €70 billion, but by 2014 that is projected to fall to €15 billion, creating a huge gap in demand. The CLO unwind, as it is commonly referred to, will make a significant impact but not take hold until later this year. “The existing CLO pool still forms a material part of the market bid today as funds are being re-paid from bond refinancings,” advises Matthew Gibbons, co-head of leveraged finance at BNP Paribas.

Investment banks have scaled back their leveraged finance operations since the crisis, but they remain keen to underwrite risk through their ‘originate to distribute’ model whereby they arrange a bridge loan for a financial sponsor then syndicate it to investors as quickly as possible.

Gibbons adds: “As a bank we have always adopted a prudent approach to holds so our model has not changed substantially and we continue to hold loans after syndication. If there has been a change over the last few years it is that there has been retrenchment by some lending banks to their domestic markets.”

The big change in supply terms is that banks no longer manage big CLO funds, which used to hoover up so much supply. But even the more conservative lenders are eager to exploit investors’ desire for high beta products. “There is always a risk of a hung bridge of a syndication going wrong,” says one head of leveraged finance, “but banks are typically holding smaller chunks post-trade.”

The transatlantic mismatch 

The thinness of the European market is forcing the region’s borrowers to tap the US market instead. Last year, the volume of US-marketed leveraged loans by non-US borrowers reached a record high of $66.4 billion, more than double the $28.7 billion borrowed in 2011. Perreve adds that a record 40 percent of European high yield issuers priced trades in dollars during 2012.

Virgin Media has continued this trend of tapping the US market as it issued a mixture of high yield bonds and loans to help fund the acquisition by Liberty Global. The buyout is being backed by a total £2.925 billion-equivalent [$4.53 billion] loan as well as a £2.3 billion-equivalent high yield bond. The loan portion includes a split between a £600 million tranche and a much bigger $2.755 billion tranche, which was expected to price a minimum of 50bp cheaper than the sterling tranche. “The principal difference between the US and European primary loan markets is that the US market is broadly open, whereas in Europe, the market is being more selective,” says Oh.

The favourable pricing that Virgin can achieve in dollars versus sterling suggests the move by European companies to tap the dollar market is not simply driven by a lack of demand at home. Gibbons adds: “Clearly the US dollar market is an important market to go to for substantial deals, but it’s not just about availability. Borrowers take other considerations into account when accessing the US market such as the ability to use covenant-lite structures and more favorable margins.”

Oh agrees, commenting: “The explosion in risk-taking is leading to an increased appetite for leveraged loans and a higher demand for looser covenant structures.”

The rise in cov-lite loans has led some to voice the concern that the market is becoming dangerously frothy. “There is a misperception outside the alternative asset management community about cov-lite structures,” Oh believes. “They are more widespread than you think – around 55 percent of new issues are cov-lite. Also, they are associated with low quality companies but in fact the reverse is true. It is the better quality companies that tend to issue cov-lite loans because they can. Covenants provide a useful warning system but they are not the only way to analyse a company’s prospect of default.”