"With each new term sheet you are seeing something else squeezed," says Charlotte Conlan, head of leveraged syndications at BNP Paribas. "Either there is more flexibility for the sponsor or fewer options for the lender."
Deal supply may be low, but the 2011 leveraged loan market has an air of invincibility reminiscent of the boom years of 2006 and 2007. Sliding margins have been the order of the day, and four deals that were in auction at the start of June Astra Tech, RAC, Securitas and V Ships are all set to have debt packages of more than five times leverage. The financing for one of the deals could reach 6.75 times, bankers say.
But despite this confidence, the long term future of the leveraged loan market remains uncertain. Beyond concerns that regulation will restrict bank lending capacity, the CLO market over half of the investor base in 2007 is showing few signs of rebirth. And to make matters worse, the strong demand that the sector is displaying for paper this year is only temporary, with most of the previous generations reinvestment periods set to expire in 2012.
With much of the 2007 LBO vintage still to be refinanced, the leveraged loan market will need to continue to attract new money, meaning the aggression shown in 2011s market must be kept in check.
Built on enthusiasm
"Leverage levels have grown very fast," says Conlan. "Instead of moving gradually from one stage to another, weve jumped two or three steps because there appears to be market tolerance for it. But maybe some structures are built more on enthusiasm than concrete fundamentals."
Competition among underwriting banks is high, and seeing deal after deal fly is daring some to compete more aggressively to win mandates, which for some are precariously hard to come by.
On one unnamed potential LBO, says one banker, a few investment banks offered a whole turn of leverage higher than the borrowers group of European relationship banks.
"In the absence of a real concern about underwriting risk, banks have just continued to push terms," says Conlan. "There seems to be a belief that you can sell a deal simply because the last one sold well."
Prepayments help with up to Eu10bn of them in May from former jumbo LBO names such as Nycomed, Amadeus and Phadia.
"There is still a limited supply of loan product," says Peter Lockhead, head of sponsor leveraged finance EMEA at Bank of America Merrill Lynch in London. "We are worried the market is a little overheated and that sponsors are pushing on leverage, pricing and equity cheques."
Ironically, the strength of most corporates is working against the LBO market. Vendors have high price expectations and companies have generally emerged from the crisis in good shape, meaning they do not have an urgent need to sell businesses.
Lack of supply has also put pressure on pricing. The first quarters LBO loans finally saw the 450bp-500bp margin range the norm throughout 2010 be broken as Spanish tin can producer Mivisas double reverse-flex triggered a chain of similar moves for deals such as Integrated Dental Holdings and Novacap.
While these developments were generally seen as fair, more recent deals have pushed even harder, meeting some resistance from investors.
"The loan market is never in perfect equilibrium, so you will always have periods when a technical imbalance leads to tighter, or indeed wider, spreads," says Alan Kerr, co-head of Harbourmaster Capital. "Fundamentally, it is right that spreads have come in because the credit outlook has improved, though to some extent, it may have been overdone.
"A few recent primary deals have had tighter margins than expected, so weve either not invested or invested less than we were going to."
Indeed, May gave some encouraging signs of investor resistance, suggesting that the weight of technical pressure on credit fundamentals could be controlled.
Gaming company Gala Coral, recently emerged from restructuring, was forced to push the margins of its £825m bullet loan up to 500bp after a group of funds made it clear that the risk needed to be better reflected in the margins.
And French catering services firm Elior withdrew an amend and extend request after 40% of lenders rejected its proposals, saying the fee and margin uplift on offer was insufficient.
"I dont see spreads coming in a huge amount," says Dagmar Kent-Kershaw, head of credit fund management at ICG. "While the CLO buyer has a technical need for paper and this has caused pricing to tighten, they are not the only buyers in town.
"Banks are buying loans but under a very different capital regime, and the other institutional buyers look at relative value. Loans are not priced in isolation from the rest of the world."
The Eu800m term loan B backing BC Partners acquisition of Gruppo Coin an Italian fashion retailer was also launched into syndication at 500bp in May. But Picard Surgelés, the French frozen food company, was able to cut pricing on its Eu625m LBO loan, raised when the markets recovery was only just beginning in 2010, to 400bp across both bank and fund tranches in April.
Most market participants see this price differentiation based on credit quality as healthy, and it is something that has not traditionally been the norm in the European market.
"It was always somewhat peculiar in the past that the leveraged loan market would only use leverage as a bargaining tool rather than pricing also," says Lockhead. "The high yield market has traditionally been significantly more adept at understanding there are two levers you can pull."
Pushback from investors may be the best way to keep structures sensible and pricing attractive.
"If too many aggressive deals come at the same time, we should see differentiation between credits and structures which may lead to a widening of pricing," says BNP Paribass Conlan. "Deals that follow would then have to come out with similarly higher margins, so pricing should be self-regulating."
Refi wall still standing
That the market is discussing structures and pricing sensitivity is a good sign and shows it has made impressively fast progress since being out for the count in 2008 and 2009. But it will need to grow its capacity even more quickly if it to cope with what is around the corner the refinancing wall. According to Standard & Poors, in Europe 2014 and 2015 are the "big years for loan maturities... with Eu37.4bn and Eu46.1bn maturing, respectively. These companies will also typically have term loan A/revolving credit facility paper maturing one year earlier, adding to the pressure."
Critics of the term refi wall point out that it is a truism to say that the market is facing a wall of maturity all debt matures. However, the difference in the leveraged loan market is that the CLOs that provided these loans may not be around when the deals come up for refinancing.
The result is that, although prepayments from high yield refinancings and IPOs may make life difficult for portfolio managers, extra liquidity is absolutely crucial.
"Prepayments are a good thing in the long term, and that outweighs the worries about short term pressure," says Volkhardt Kruse, head of syndications and sales at Commerzbank. "We dont want to find ourselves with a huge funding gap in 2015, and IPOs as well as high yield are helping to address the 2014 and 2015 maturity wall."
So far, the refinancing wall has not proved problematic, with defaults remaining low.
"We feel the refinancing wall hasnt been an issue for a year or so now," says BofA MLs Lockhead. "Investors mostly lost money because they needed liquidity and started to sell, causing secondary prices to drop. But the underlying businesses have mostly been pretty robust."
Others, however, warn against the complacency that 2011s strong market risks creating, with attractive terms needed to attract new participants.
The new money is required to replace the last generation of CLOs. Skin-in-the-game regulatory requirements, alongside challenging arbitrage, mean the CLO market is unlikely to return to its past glories.
"The refinancing question is definitely something worth looking at because today there is only partially an answer given the lack of new CLOs," says Commerzbanks Kruse. "That said, I am 100% confident there will be an answer and we will find sufficient liquidity."
Kruses optimism is echoed across the market, but nobody is willing or able to say in what form the loan investor base will reappear.
"We are in a smaller leveraged loan market," says Lockhead, "but the bond market more than makes up for that."
The bond market has fulfilled its task of ensuring that the European leveraged debt market is not shrinking materially, but CLO managers themselves are confident that new issuance will return to Europe, if not to the same scale as before.
"Obviously the regulations make securitised vehicles more challenging," says Kent-Kershaw. "But the market for loan funds with leverage will come back in one form or another."
Harbourmasters Kerr adds: "They will be done by institutions who have a track record of managing CLOs well and who are prepared to invest to meet the retention requirements for new issuance."
Even without CLOs, loans are an attractive option, investors say.
"There is a broad range of potential ways for institutional investors to get exposure to leveraged loans," says Kerr. "Frankly, even on an unlevered basis, the returns for leveraged loans are very interesting."
A mixture of unlevered funds, unlevered managed accounts and vehicles such as prominent capital vehicles are likely to form the buy-side landscape, investors say.
It seems unlikely, therefore, that high yield bonds are set to take over the LevFin world."Loans have inherently been a very stable asset class and a suitable one on which to apply leverage," says Kent-Kershaw.