The good news is that the most experienced investors in the European leveraged loans arena remain broadly positive about the outlook for the market. "We are fairly constructive on the market," says David Forbes-Nixon, chief investment officer and head of European operations at Alcentra, which has so far closed five CDOs and one European total return credit fund, and which now manages a total of Eu2.3bn. Of that total, Eu1.8bn is in senior leveraged loans, with a further Eu300m in mezzanine and the balance in high yield.
Given that Alcentra can write individual tickets of as much as Eu100m in the senior leveraged loan market and Eu50m in mezzanine, Alcentra is clearly one of the most influential investors in the fast-growing leveraged loan market, which Forbes-Nixon believes will see total issuance of more than Eu50bn in 2005.
Forbes-Nixon says he is encouraged by the recent growth of the leveraged loan market, as well as by its increased diversification. He is also confident that the market can continue to deliver healthy returns over the foreseeable future. "I believe there is still value to be found in the leveraged loan space, especially relative to other asset classes," he says.
The less positive news is that Forbes-Nixon is becoming increasingly wary of a market in which he sees a rising number of danger signals. Over the last year or so the emergence of those "red flags" has prompted Alcentra to reduce the number of transactions it buys into but write bigger tickets in the deals it invests in. "On average I would say we buy into about 45% of the larger senior leveraged loans and 30% of the mezzanine deals we look at, which means that our average hit rate is about 40%. To put that into perspective, that proportion has probably fallen from about 55% a year ago."
Leverage on the rise
That increasing decline rate, says Forbes-Nixon, has largely been a response to rising leverage levels in the market. To date, he believes that in some of the larger transactions those increases have been warranted. "Particularly in the last quarter of 2004 we saw a number of cases in which leverage levels have been pushed out," he says, adding that the three most conspicuous examples of that process were the buy-outs of the AA, Saga and VNU. "But those were all very strong deals that will be able to withstand the leverage being put on them because they have unique business models, they are market leaders and they are highly cash generative."
But as demand continues to outstrip supply in the leveraged loan space, the obvious danger is that investors will be presented with a growing supply of buy-outs in which stretched leverage multiples are much less appropriate. "We've clearly had a very benign market over the last three years," says Forbes-Nixon. "This year I think investors are going to have to be extremely vigilant because it is becoming apparent that the seeds of the next downturn are being sown right now in the leveraged space."
Aside from stretched leverage multiples, Forbes-Nixon detects a number of other warning signals that investors should be mindful of in today's market. "We're seeing more transactions being sold with PIK notes, which suggests that there is not enough debt capacity within companies to service their debt, which is one red flag," he says. "Another is that we're starting to see equity contributions coming down a little and purchase price multiples going up. And a third is that a growing number of deals are using larger second lien tranches. What we haven't seen yet is companies writing asset sales into their business plans as a means of paying down debt, which would be another negative sign."
Nevertheless, given that LBOs that fail tend to do so within two to four years of their inception, Forbes-Nixon says that he expects any excesses in today's market to start manifesting themselves in accelerating default rates beginning in the second half of 2006.
But far from being apprehensive about what that might mean for the Alcentra business, Forbes-Nixon suggests that he is relishing the challenges that a more difficult market will bring. "We think that the next three to four years will be a very interesting time in the market with far more differentiation of investment managers," he says. "The larger ones with significant resources and experienced credit professionals are going to outperform those with small teams and less experience."
Front of the queue
So how would a player like Alcentra respond to a more challenging environment for the leveraged loan market? Forbes-Nixon believes there are three essential drivers for outperforming other institutional loan managers, the first of which is for a manager to make absolutely certain that it has the ability to source good product. "Especially in more difficult markets you need to be certain that you are shown all the deals in the market, and to do that you need to have developed very good contacts with the banking and the private equity communities," Forbes-Nixon explains.
For a manager like Alcentra, having the capital to be able to commit Eu100m to a single deal obviously helps to ensure that it is always towards the front of the queue when it comes to seeing new transactions and being offered worthwhile allocations. By equally obvious implication, much smaller funds that are unable to support the market with a relatively consistent flow of meaningful orders are likely to find themselves nearer the back of the queue.
A second key driver for success, says Forbes-Nixon, is to maintain what he describes as a strong credit culture — which means being prepared to hire and retain the most experienced analysts. "The members of our investment committee have an average of 13 years experience of this market, and in our analysts' pool it's about 10 years," he says. "That is valuable, because when you're approaching a downturn in the market it clearly helps to have people who saw some of the cracks appearing in previous cycles."
Forbes-Nixon's third prerequisite for weathering the storm in a more challenging market is probably one that is more broadly applicable to a wider range of investors in the leveraged loan space that do not necessarily have the capacity to commit Eu100m to an individual transaction or to employ armies of highly experienced analysts. This is to make the most of the much improved liquidity levels in the secondary market for leveraged loans.
"We saw prepayment rates of about 30% last year," says Forbes-Nixon, "and we're confident that this year's rate will be about the same. That means that with a portfolio of senior loans worth Eu1.8bn we will need to source about Eu600m of new product just to manage our existing funds — and that is assuming we raise no new money."
Over and above that natural annual portfolio churn rate of 30%, Forbes-Nixon says that 10% of Alcentra's leveraged loans portfolios will also be turned over in a typical year. That is in line with the group's strategy of continually aiming to identify the weakest 10% of its holdings and offloading those into the secondary market.
"An essential question to ask is: how good are you at selling positions?" Forbes-Nixon explains. "Most investors with good filter mechanisms can pick out the stronger credits in the primary market. It's much more tricky to manage your book by identifying weaker performers ahead of the competition and selling those positions in the near-par zone of the market." That discipline, he adds, need not be one that is restricted to poor credits, but which can (and should) also be applied to profit-taking in the case of out-performers, given that the upside for loans acquired at par will seldom be higher than 102.
Investors' opportunities for managing positions in the leveraged loan market, says Forbes-Nixon, have broadened substantially over the last year or so in line with the increasing liquidity in the secondary market. "The liquid part of the near-par market used to be in the very narrow range of between 98 and par," he explains. "But with more institutions now playing in the market that range has broadened to between about 95 and 101. That is very helpful for portfolio managers because 18 months ago if a credit fell from the narrow 98-100 range it would tend to go down by 15 points or so, or straight into the impaired space of the market. We now have a broader near-par market which means there is ample liquidity down to about the 95 level."