First quarter volumes were down across all loan markets, and leveraged lending was no different — down 26% year on year in 2012, according to Dealogic.
But it is the M&A environment, not the debt markets themselves, that is to blame for the lack of leveraged loan activity. With economic growth so modest, taking a punt on an acquisition is a risky business: just ask investment-grade loan bankers how desperate they are to see a smidgeon of M&A.
So finding businesses with the cashflow expectation to withstand a high leverage is even harder.
Meanwhile, private equity vendors are holding out for prices that many bankers find fantastical. In addition, improving public equity markets are convincing some sellers that their companies are worth more than buyers are willing to pay.
Obviously, the leveraged lending sector will have to shrink: regulation will limit the amount of bank capital available to be invested in leveraged loans, and new CLOs to replace the last generation remain a pipe dream in Europe. Moreover, the instrument not being Ucits-compliant prevents loan managers raising retail money for loans as they do in the US.
But not being able to replace the previous generation of CLOs in its entirety is a reflection on the fact that the buy-out industry had become too large in the first place.
It will be the bloated generation of 2006-2007 LBOs that will suffer from the funding gap, and defaults may well rise.
But this should not cloud the fact that the investment case for leveraged loans in new deals is compelling: secured instruments, with strong covenants and high yields.
And the lack of new CLOs could be a good thing for the market. The way CLOs are set up means that repayments weigh heavily in loan managers’ pockets — they have to be invested to a certain degree or they are obliged to redistribute their funds to the AAA investors, or whoever is on top of the CLO structure at the time. To pick up their management fees, the portfolio heads must remain invested, even if the spread is too low for the credit quality.
This desperation to invest was the problem in 2006/07, and was also what drove the market to overheat in 2011 — with disastrous consequences — as repayments from high yield overwhelmed CLOs.
Investment managers in other fund structures do not feel such pressure to reinvest, moving credit quality much higher up the list of priorities. A market not so driven by CLO liquidity should therefore be much more able to keep its discipline.
Moreover, higher loan margins (around 300bp higher than at the peak of the boom) mean that private equity can no longer get away marginal deals based on high leverage and cheap debt. As new loan funds are not leveraged, margins will not fall very far. An unlevered fund simply cannot buy loans priced at 250bp over Libor, as CLOs used to.
This is a fundamentally healthier model for leveraged finance, as sponsors will no longer be able to binge on underpriced loans that allow them to lever companies to inordinate levels. Private equity will have to show operational, not just financial, astuteness.
As for the banks, well, they will also have to shrink in number, and this is no bad thing. The one thing that could jeopardise fundraising efforts by loan managers is another spate of over-levered, cheap LBOs. With today’s barren supply, there is a real risk that competition between the more than 25 banks looking to underwrite deals in Europe will drive overly aggressive structures — just like last year.