The fight for Europe

Having dodged the refinancing bullet, banks are as keen as ever to embrace European leveraged finance. But in the face of stiff competition from alternative lenders, can they dominate the market in the long-run? 

Of all the disasters that the banking sector has faced since 2008, one did not quite live up to its billing. The refinancing crunch that was widely predicted to scupper the private equity industry and leave banks unable to shift massive amounts of hung loans turned out to more of a period drama than a full-blown crisis. 
“The unwinding of post-crisis leveraged finance positions by banks has been for the large part orderly,” argues Matt Grinnell, head of financial sponsors for Europe, the Middle East and Africa at Barclays. “Some banks with big hold positions sold out of them during the wave of re-financings via the high yield market. Overall, banks have exercised a large degree of patience, rather than selling simply to close out the position. Generally speaking, they are not under such intense pressure now as they were.”

From bank to bond funding 

The reason banks did not hit the refinancing wall was down to the high yield market, which rode to their rescue as part of the secular shift from traditional lending to capital markets that the financial crisis triggered.  The high-yield market enabled banks to exit positions they were holding as they sought to delever, while giving banks vital breathing space to avoid being forced sellers of debt when the likes of Apollo, Cerberus or Anchorage came knocking for cheap assets. 

Oliver Duff, global head of leveraged and acquisition finance at HSBC, says there were fewer collapses than people had predicted. “What has been very helpful for the market generally is the extent to which high yield market has taken up the slack.  For years Europe has been trying to develop a proper high yield market but its success has been sporadic. Now there is a much more stable, more mature and diverse. European high yield market with many more knowledgeable players.”

While the refinancing crisis was averted, the 2008 financial meltdown has reshaped the leveraged finance market and with the green shoots of a Spring recovery evident in LBO activity, now is a good time to evaluate the new world order. Many private equity firms are sitting on uninvested equity, while the launch of a handful of CLO funds in Europe – and a much broader rebound in the US – coupled with the emergence of more traditional institutional investors searching for yield by investing in loans and high yield, provide cause for optimism. But what of the banks, the erstwhile masters of the leveraged finance universe?

Grinnell adds: “The business model currently deployed by most banks in the European leveraged finance market bears a closer resemblance to the US than at any time in the past.”

The convergence with the US leveraged finance model of originate-to-distribute is a cornerstone of banks’ ability to compete in a world where capital is more expensive and less readily available,  and where the introduction of regulation such as Basel III has forced banks to focus on churning capital as quickly as possible on the most liquid and attractive credits.  Prior to the crisis, investment banks would underwrite leveraged loans which would be syndicated to banks, CLOs, credit funds and high-grade investors. At the peak of the market, banks accounted for 30 percent of the market, with CLOs taking 40 percent.

Is that Wells Fargo over there? 

Now, banks, while still holders of loans, have retrenched to their home markets and will pick the transactions they participate in depending on the broader relationship that they have with the issuer. The orderly unwind has been possible as the balance has moved from bank funding to bond funding, a transformation that is supportive of the originate-to-distribute model, where a bank can churn capital quickly into the bond markets and minimize the use of their balance sheet. Even in a Basel III world, this is a core business for the world’s biggest banks.  Duff adds:  “Competition at the larger end of the leveraged finance market has been steadily increasing particularly where a high yield bond is being considered. The rapid execution and term out of bridge facilities allows banks to churn capital quickly and therefore appeals to both investment banks and retail banks alike.”

The new competitive landscape includes the perennial leaders in leveraged finance and it is also attracting the potential for new entrants.

In February, when US investor Warren Buffet’s Berkshire Hathaway paid $21 billion for food group Heinz, leveraged finance bankers were initially surprised to see US bank Wells Fargo as a lender. Wells Fargo is one of the best-capitalized banks in the world and with little or no exposure to investment banking at the time of the financial crisis, its balance sheet is untainted. Now it is starting to spread its wings in investment banking and last year it started an expansion of its international corporate banking business.  Leveraged finance bankers in Europe say that the firm has started offering real estate loans at aggressive rates and that Wells Fargo may soon start offering leveraged lending outside the US.  The bank did not respond to emails or calls seeking comment on its international plans while US bankers point out that Wells Fargo’s appearance on the Heinz financing was down to the fact that Berkshire is Wells’ biggest shareholder, rather than an indication of a broader push.

A more familiar name said to be keen to participate in leveraged finance is Allied Irish Bank, which was rescued after Ireland’s banking systems collapsed under the weight of sour property loans granted in the last boom.  AIB did not return calls. 

The prospect of Wells Fargo launching a dedicated leveraged finance operation follows a concerted post-crisis push by Bank of America Merrill Lynch to beef up its international lending and there is no doubt that European banks are nervous of a US land-grab. Duff says: “The playing field between the US and European banks does not feel completely level at present. It appears that Europeans have adopted Basel III earlier than their US counterparts and are consequently pricing risk differently. US banks are therefore trying to take market share while they can.”

Shrinking balance sheets, shrinking power 

With commercial and retail banks playing a less prominent role in loan syndicates, the investor universe is also starting to resemble the US model. Patrice Maffre, head of acquisition and leveraged finance for EMEA at Nomura, says: “In the US, most of the term liquidity is provided solely by institutional investors in the loan and bond markets. We are seeing this transition in Europe and it is a welcome development because it allows for more price elasticity and active trading of loans as a genuine capital market emerges for non-investment grade credits. It also means that banks with a strong market-read can secure the best execution for their sponsor or corporate clients.”

This convergence is welcomed by leveraged finance specialists because it places greater importance on their market knowledge and less on their balance sheets – a crucial feature in a post-Basel III world where non-investment grade loans consume high quantities of risk capital provisions.

For example, Credit Suisse is a leading player in the high yield and leveraged finance market, both in terms of origination and sales and trading and the resurgence in the asset class has vindicated its decision to retain its leveraged and acquisition finance business as a core activity.  As a Swiss bank, it is subject to much higher capital charges that other European firms, let alone some Basel III laggards in the US. In terms of originate-to-distribute, this does not put it at a disadvantage to its rivals. For example, the bank was lead arranger to Virgin Media on the high yield bond and term loan to support its $25 billion acquisition by John Malone’s Liberty Global in February and is also working on the Heinz deal.   Having a strong sales and trading business is crucial to providing market insight and identifying investor demand and it is also enabling banks to pick their spots in terms of deals and sectors they will invest in.

But banks might suffer at the margins, where companies require a bank to lend in return for bond business. “Banks with less balance sheet power can still be top-notch houses on event-driven deals, but they may not be able to compete with the same intensity across the piece.”

Goldman Sachs is a force in leveraged finance but, while not boasting the balance sheet of JP Morgan, has other tools to compete with, such as its firepower in third party senior debt and mezzanine funds, which enable it to take final holds where it is commercially viable. Morgan Stanley, though not a traditional balance sheet bank, has been beefing up its leveraged and acquisition finance operation (this month it hired Citigroup veteran Yannick Pereve) and in the US it has additional capital to deploy through a lending venture with Japanese Bank MUFG.