The leveraged finance market in Europe is a far cry from what one banker remembers as a “cottage industry” in the 1990s and early 2000s and was usually seen as a less mature, shallower sideshow to its US counterpart. Indeed, bankers in London now see their business as part of a global non-investment grade market.
Two trends have delivered that result, says Nick Jansa, global co-head of leveraged debt capital markets at Deutsche Bank in London. “First, global institutionalisation, a move from European money and US money to what is now global money; and second the convergence among products.
“So, where the majority used to be loan investors or bond investors and European investors or US investors, we now have the majority as global credit investors.”
While that doesn’t apply to all institutional investors — and CLOs, a key element of the institutionalised loan market, generally cannot buy high yield bonds — many investors have become product agnostic, says Stefan Povaly, co-head of sponsor financing, EMEA, at JP Morgan in London. “They just look through to the ultimate risk regardless of how it’s wrapped or packaged,” he notes.
The key to the blurring of lines between high yield bonds and leveraged loans has been the growing use of covenant-lite documentation since the market began to institutionalise away from being bank-dominated in the early 2000s. It has got to the point where bonds and loans are primarily differentiated only by the call protection embedded in bonds, and usually the fixed versus floating rate formats.
Cov-lite, while still resisted by some old-school commercial bank investors, is widely accepted on the institutional side — as Jansa says: “Institutional investors have been investing for years in credit without maintenance covenants via the fixed income markets.
“As the European leveraged loan market moves closer to the bond market in terms of documentation, as the US did a few years ago, private equity owned companies can choose a product that is very similar to a bond in terms of documentation flexibility but without the call protection.”
Martin Luehrs, head of leveraged loans for EMEA at Morgan Stanley in London, points out in a borrower-friendly market, the two trends are self-reinforcing, with “transatlantic” deals helping to introduce features and structures common in the more mature US market into Europe.
“We are seeing high yield bond concepts being adopted in the leveraged loan market, plus a convergence of terms across US and European markets,” he says. “The US market is both more mature and advanced. US terms as a result tend to migrate into Europe via those cross-border euro tranches and subsequently into mainstream European financings.”
The result is a European market that is, says Povaly, “a more credible counterpart to the US. It is a very cross-border market and I see more runway for that as more European companies will need to raise both dollars and euros.”
Stable structure
Issuance volumes in Europe have followed the shift towards the growing attractiveness of the now more flexible loan product. There has been a shift from high yield bonds to leveraged loans, with loan volumes surpassing high yield bonds in Europe for the first time last year, says Povaly. “It has been borrower-led — companies are compelled by the fact that it’s easy to arrange, feels less public than a bond, and for the most part is freely repayable. Cov-lite is the same flexible funding set-up investors are used to in bonds in loan format.”
Corporates still tend to use bonds more as they want to lock in low rates, push maturities out as far as they can and get the lowest possible cost of capital, but the shift to loans has also been bolstered by the interest rate cycle.
“There’s been an asset allocation shift from fixed rate to floating rate money,” says Povaly. “Especially for longer term instruments, investors, whether pension funds, endowments or SWFs, would rather be in floating rate instruments in this
environment.”
Deal execution has also sped up, again bringing leveraged loans closer to high yield bonds, as the investor base has changed, says Luehrs. “The information package made available to investors opting to remain public on a loan largely mirrors what high yield investors are accustomed to,” he says. “That was not the case a couple of years back where instead more investors would elect to remain private and as a result more substantial information packages were prepared and shared during syndication.”
Trouble ahead
But are looser documentation and red-hot pricing conditions setting the market up for a fall when the credit cycle turns?
Luehrs says two factors are boosting stability. The first, perhaps surprisingly from an investment banker, is regulation. “The new regulatory environment has had a net positive impact on the market,” he says.
“This is a market with a supply and demand imbalance, where the various markets are converging, and where investors are increasingly remaining public and therefore do not have access to, nor can review due diligence materials. The new regulatory environment has, among other things, also ensured that capital structures don’t get out of hand and this is definitely positive for the longevity of the market as a whole — and something we did not benefit from pre-credit crunch.”
The second is the importance of the long-term capital provided by CLOs. Bankers say the market was still functioning on pre-crisis CLO money as late as 2012-13, while euro CLO formation remains strong with a record €17bn raised in 2016. In a downside scenario, CLOs are expected to deploy cash when loan prices dip rather than waiting for a larger sell-off.
Even if a changing supply/demand balance allows some ‘natural’ loan investors and ‘natural’ bond investors to push back against the terms they least like, bankers are confident the bond versus loan and Europe versus US convergence trends are here to stay, even when the market turns.
“The low interest rate environment has meant lower risk, lower defaults and lower yields,” says Jansa. “But the globalisation and product convergence trends are secular trends that have been happening independently of that over the last 20 years.”
Funding opportunities are good for financial sponsors doing leveraged buy-outs, but they are not the only aspect of the business that has improved. Reputations and the public perception of the industry once described as comprised of “locusts” by German social democrat politician Franz Müntefering appears to have changed, too.
“Private equity has matured over the past few years and there’s now a broad acceptance of them and what they do,” says Povaly. “There’s now an overhang of capital chasing deals so sponsors have had to be more nimble about how they create value, whether that’s doing add-on acquisitions, or helping portfolio companies grow into other regions.”
For the investment banks running the deals, leveraged finance is an essential element of the business, even if borrowers can strike as tough a bargain on arranger fees as they do on pricing with investors.
“It’s a strategic product for investment banks, linking up the M&A franchise and leveraged capital markets at the entry point and equity capital markets and potentially M&A again on the exit. It is therefore an integral part of the business model,” says Luehrs. “A borrower-friendly market suggests an environment where there is an element of margin and fee compression.”
For all the changes in the market over the last two decades, however, some still see it as fundamentally the same business they’ve always been in. “The leveraged finance market is still about the loan and bond products, it’s still providing companies with capital whether to refinance or to grow via acquisitions,” says Jansa.
So what’s different?
“What has changed is that global markets are now more sophisticated in terms of the people who work in them, their analysis, their information flow, the professionalisation of the market, the regulatory environment, the transparency and the technology involved,” he says.
