Europe’s symbiotic leveraged loan and CLO markets are both faltering, with issuance ranging from scanty to impossible. As they try to find a way out of the blockage, market participants are debating how much the problems are internal to each market, and how much their relationship is causing a problem.
After a slight pick-up in early April, which appeared like a revival of the CLO and leveraged finance markets, a dry May and June are worrying market participants. New leveraged loans are scarce, while CLO issuance is minimal.
Each market has a major internal problem.
CLOs are stymied partly by the irreconcilable demands of the investors in their different layers of capital. The investors that buy triple-A CLO paper are demanding so much spread there is not enough left on the underlying assets to attract investors to the equity tranche.
But rather than reduce their spread targets, the triple-A investors are turning to the US CLO market. There is some space for them there, because JP Morgan, Citigroup and Wells Fargo, traditionally the biggest triple-A buyers, are not active at the moment.
In European leveraged loans, meanwhile, investor demand is reasonably healthy, and there is some activity — mainly amendment and extensions.
But issuance is still far below normal.
“The main reason is that there is not much M&A happening,” said the head of European leveraged finance at a bank in London. What acquisitions do happen are mostly being financed by direct lenders, he said.
CLOs go hungry
But the health of each market also affects the other, in a ‘chicken and egg’ relationship.
There is a broad consensus that the CLO market is being weighed down by levfin’s problems, and CLO managers are short of collateral to buy due to the levloan market being quiet.
Slow leveraged loan issuance is affecting CLO formation, said the head of European leveraged finance at one bank.
“[CLO] deals are waiting to launch,” said Charlotte Conlan, vice-chair of global leveraged finance at BNP Paribas in London.
If they cannot buy enough newly issued loans, she said “they will use the secondary market to top up […] but cannot rely solely on it”.
The head of leveraged capital markets at another bank said: “If there would be more primary loan supply, CLOs would go ahead. I think it is the lack of primary issuance that is preventing CLO formation.”
Buyer group missing
A stagnant CLO market in turn takes away one of the major sources of demand for leveraged loans.
“We need them and they need us,” said Conlan. “[CLOs are] the core component to leveraged lending.”
A global head of syndicated finance in Frankfurt agreed: “CLOs are the major recycling for leveraged loans.”
A head of high yield syndicate in London said there was “good demand for high quality [levfin] deals. But unless the CLO market picks up in the coming months, we will see much less liquidity available”.
Other bankers are sceptical that the CLO market is causing a chill in leveraged finance at the moment.
The head of leveraged capital markets blames the lack of lending squarely on the shortage of M&A. “If there would be 20 more CLOs now, there still would not be much primary,” he said.
The M&A drought also hits CLOs directly, through their existing portfolios.
“I do not think liquidity is growing very rapidly,” said the head of European levfin, referring to demand in the leveraged loan market. Most liquidity in that market, he said, usually came from recycling existing money held by CLOs.
However, the lack of M&A means few old leveraged loans are being repaid when the borrowers are bought.
“The repayment [of leveraged loans] is down to 2009 levels, at 10%,” the banker said. “In a normal year, the repayment would be at 30%-40%. If investors [including CLOs] do not get the repayment, they do not have the cash to deploy.”
What everybody wants
The one thing that would restart the flow of leveraged loans and consequently CLOs, according to the head of European levfin, is more M&A.
“The question is, when will that happen?“ he said. “People are waiting until after the long-awaited recession before engaging in a lot of M&A activity again.”
Conlan pointed out that the M&A pipeline at the beginning of this year had been “close to zero”.
The head of EMEA levfin believes the pipeline is filling. “A number of processes are expected before the summer,” he said, “so primary loans will come to the market after.”
He does not believe fear of recession is a major impediment. “With recessionary risk, you never really know when it is coming, and the economy is in a much better shape now than what we were expecting at the back end of last year,” he said.
Public-to-private acquisitions are expected to bring some new money financing, Conlan said. “But time to market makes them more difficult to underwrite,” she acknowledged.
In private equity, there is still dry powder to deploy and assets that need to be sold to return money to investors.
But there is a separate chicken-and-egg relationship here, too. “If the financing market were bullish, it would drive M&A activity,” said one banker.
“PE firms will need to put companies on the block at some point, and that is starting to happen now,” said the head of EMEA levfin. “If those deals go well on both the M&A and loan fronts, that will push the better and bigger companies to also engage in acquisitions.”
The new normal
The major block to M&A is the high valuations sellers still expect, even though potential buyers are coping with a much higher cost of debt, said the European head of levfin.
“The M&A market needs to work through the fact that enterprise values [achievable] have come down, on the basis of much more expensive funding costs on the debt side,” said the head of EMEA levfin.
The excitement around the few dividend recapitalisations and loans for acquisitions that have come to market is too early to be called a “levfin revival”, as a leveraged finance banker had predicted.
However, if the long-anticipated pick-up of M&A materialises after the summer, the market can expect healthier markets for both leveraged loans and CLOs.