S&P warns European lenders over recovery prospects

The ratings agency says that there are clear signs that the current scramble for assets is undermining credit discipline in the European leveraged finance market.

Standard & Poor’s ratings services has warned lenders in Europe to take “full account” of recovery prospects when committing to leveraged loans in a new report.

The report, entitled “Plain Sailing for European Leveraged Finance Until the Liquidity Tide Turns”, said “there have been clear signs that credit discipline in the European leveraged finance market is being undermined in the scramble for assets”.

Paul Watters, head of loan ratings at Standard & Poor’s, told PEO that, in the last three to six months, institutional investors, that in the past would have been invited into transactions at the second stage of syndication, are now committing at a much earlier stage, while the traditional banks have struggled to get credit approval “at anything like the same timescale as institutional investors”.

Standard & Poor’s European Leveraged Loan Index, which comprises 327 facilities with a par value of €57 billion ($71 billion) and tracks leveraged loans held in European CLO portfolios, reported that 77.3 percent of the index was rated B+/B at March 30 2006.

This compares with 13.8 percent of the index rated at B+/B at the end of 2002 when the index first started tracking leveraged loans and 53 percent at the end of 2004.

Standard & Poor’s said its concerns were corroborated by an increase in the number of companies breaching covenants at a relatively early stage. According to recent research by the ratings agency, up to one-third of transactions that breached covenants in 2005 were launched less than a year before.

Watters added that, in the first quarter of 2006, 20 percent of loans launched on the market were effectively for the purpose of raising dividends for recapitalisation deals, where dividends are paid out to sponsors. “Where portfolio companies are performing in line or better than expected, the sponsors are being quite opportunistic in terms of dividend recapitalisation deals, which puts the leverage back to at least initial levels if not higher,” said Watters.

If market conditions tighten as expected, continued Watters, the expectation is that private equity firms will focus more on refinancing the outstanding debt of better-performing portfolio companies, “rather than recapitalisations, which implies taking on more debt. In that way, we would expect to see more LBOs migrating up the credit rating scale towards a BB rating in a way that we don’t see currently”.