A growing swell

The leveraged loan market is gathering momentum. After a strong first half, investors and sponsors appear to be lining up for what is expected to be an even stronger conclusion to 2013. European leveraged loan issuance has already surpassed 2012 totals. On the other side of the Atlantic, Barclays adjusted its US leveraged loan estimates by a whopping $110 billion to $115 billion, increasing its estimate for total issuance on the year to between $340 billion and $360 billion, according to a Bloomberg report.

A number of factors influencing the US and European markets have combined to create something of a perfect storm for leveraged loan investors, sources say.

“Coming into the year, the expectation was that volatility would be low for the rest of the year,” Barclays credit strategist Eric Gross told Bloomberg. “What we didn’t foresee was that fears of an early tapering would take hold in early May.”

Barclays did not respond to a request for comment.

Gross is referring to the impact of statements made by Federal Reserve chairman Ben Bernanke and others that signified an eventual paring down of asset purchases implemented by the Fed as a component of quantitative easing. If US unemployment continues to fall – as many expect it will – the Fed will likely take its foot off the gas for asset purchases, which in turn removes downward pressure on interest rates. Even though tapering has yet to occur, the Fed’s announcements spurred a sudden jump in interest rates, which caused investors to shift their allocations from fixed rate assets – which suffer when interest rates increase –  to floating rate leveraged loans sooner than expected.

“As an asset class, there has been generally more interest in floating rate assets,” says Scott Zimmerman of Dechert. adding that much of the market activity has largely been driven by refinancings and dividend recaps.

On the latter point, several sources have indicated that refinancings and recapitalisations have driven the bulk of the leveraged loan activity, both in the US and in Europe.

“Last year was a tremendous time for dividend recaps,” Zimmerman adds, particularly in the US, where many sponsors sought to get deals done before the hike in capital gains rates that took place at the start of the year. “That non-buyout financing trend has continued into 2013, both in terms of re-pricings, refinancings and dividend recaps.”

Repricings, refinancings and recaps accounted for more than 60 percent of leveraged loan issuance in the US last month, according to Debtwire data made available to Private Debt Investor.

“If you are approaching the latter years of your credit facility … some sponsors are taking advantage of that excess financing in the marketplace to take advantage of lower interest rates,” says Jay Alicandri, also of Dechert. “There’s an exorbitant amount of supply of capital to provide loans in the market place.”

The supply is the result of a number of factors, including the strong pipeline of CLOs, CDOs and BDCs launched by private equity firms and other non-traditional lenders early in the year. Institutional investors have picked up on the sheer quantity of available as well.

“LBO loan volume has recovered from its trough in 2008/2009, but remains well below its 2007 peak,” according to an August report from the Texas Employees’ Retirement System. “Refinancings, however, are near all-time highs as low interest rates persist and financial sponsors have been actively pursuing refinancing opportunities.”


Europe emerges

Although considerably smaller than the totals seen in the US, the wave of leveraged loan issuance has also spread to Europe.

“Europe also saw an increase in leveraged loan volumes to €23.5 billion in Q2 2013, up 47 percent from €16 billion in the previous quarter, the first quarter over the last twelve months where loan volumes have been greater than high yield bonds,” according to a mid-market quarterly snapshot from London-headquartered debt advisory boutique Marlborough Partners.

As was the case in the United States, the bulk of recent activity has been driven by refinancings, which accounted for 63 percent of first half volumes, according to Marlborough. Meanwhile, M&A activity comprised only 32 percent of volumes, a record low. 

“The market has been very sensitive to any comments that the Fed has made about QE and tapering, and that’s as much in the equity market as the debt market,” says Jonathan Guise of Marlborough, adding, however, that the European market has been more affected by, “fundamental issues like the strength of the bond market, and the fact that’s recycled a lot of money back to CLOs … and the fact that many CLOs are reaching the end of their investment periods, so they have a lot of incentive to reinvest.”

The quantity of CLO capital that needs to be put to work has created excess demand given Europe’s relatively light M&A market, he adds, which has led to higher multiples and a more aggressive use of leveraged loans in scenarios like dividend recapitalisations. The life of that capital is somewhat limited, however, as CLO formation in Europe remains well below where it was prior to the financial crisis. 

In any case, the immediate availability of capital has put borrowers in a position to negotiate friendlier terms. “The US is dominated by cov-lite, and we haven’t seen that yet in Europe. But we have seen cov-loose,” Guise says. “You’re in a pretty good position as a borrower to push the terms aggressively, and some of the larger sponsors have been very successful in doing that.”

Covenant-lite refers to agreements that do not include certain lender protections. With a large amount of leveraged loan capital chasing a smaller number of deals, many providers in both the US and Europe have been driven to agree to less protective terms, sources say.

“Covenant-lite loans have also seen a boost in volume as sponsors push for looser structures that allow more flexibility in downturns,” according to the Texas report.

The re-emergence of covenant lite (or covenant loose) may seem odd to some casual observers in the wake of the 2007-2009 credit crisis. A preponderance of debt chasing cov-lite deals seems to harken back to the pre-crisis era, which makes this development somewhat curious considering how much emphasis has been placed on risk mitigation in the years hence. However, Alicandris is quick to point out that many of the deals he has seen have been constructed at lower leverage multiples. “I don’t think we’re in 2007,” he says.

“While there’s some inkling of the memory of the recession, lenders have moved on and are supporting covenant lite deals, but maybe at somewhat lower leverage levels,” Zimmerman adds. “Loan buyers appreciate the current market requires reasonably aggressive terms in order to compete for sponsored deals.

Through 2013, sources say they will be paying close attention to how the leveraged loan market evolves in Europe, which has not enjoyed the boom of new CLO closings seen by the US throughout the year ($51 billion year-to-date as of 16 August, according to Bloomberg). As M&A activity picks up and existing CLOs’ investment periods draw to a close, sponsors may not be able to wrangle the terms they have become accustomed to within a shallower pool of available capital.

“It’ll be interesting to see what happens going forward when there’s a pickup in M&A volumes, to see if there’s enough leveraged loan liquidity when the CLOs reach the end of their reinvestment periods,” says Guise.