Follow-the-leader leveraged newbies set to suffer most
The terms of leveraged finance deals are growing ever more aggressive. The most regular borrowers are the biggest pushers of tough terms, but those who follow their example may pay the heaviest price in a market correction.
Dividend recap deals are back. If one use of borrowing proceeds is universally acknowledged as lairy, it is dividend distribution — whereby borrowers stuff a chunk of the cash freshly borrowed from investors straight into shareholders’ pockets.
Leveraged loan investors funded €7.6bn of dividends in the first nine months of the year, more than had been seen in the preceding 18 months, Moody’s data shows. They include loan offerings from well-known names in the market such as ChemicalInvest and Ten Cate.
In the high yield bond market, investors have funded just over €1bn of dividends this year. It was all in one deal for familiar HY face Verisure. They funded none in 2016.
But dividend recaps are just the start. European term loans without financial maintenance covenants represented a staggering 75% of all issuance in the first half of this year, a steep rise from 2016’s 48% for the same period. That was already a record high, beating 2014’s 42%.
In the high yield bond market, borrowers have refinanced debt, tweaking terms as they go — using net leverage instead of gross leverage as a ratio test to enable the portability clause, for instance, or paying no extra fee on redemption if a change of ownership occurs.
Borrowers can get away with this because investors are full to the brim with cash, thanks to central bank quantitative easing, which they need to put somewhere as yields plummet.
They have no reason — yet — to fear a downturn on the immediate horizon either. Moody’s reckons European speculative grade default rates are set to remain below 2% for the next year, while eurozone GDP growth has been revised up to 2% for 2018.
And that central bank support, while slowing, is not disappearing next year.
There is cause to worry, however. Newly rated borrowers are coming out with the most aggressive capital structures since 2011, according to Moody’s.
Their adjusted gross leverage at opening has jumped to 4.1 times their Ebitda for Ba rated names, and 5.9 times for B and Caa rated credits. Both those figures are at their highest since 2010.
In other words, as payback has plummeted, risk has rocketed. But the point about shocks, economic or otherwise, is that no one sees them coming.
If the European market is one big party, Brexit negotiations are lurching around drunk — ready to knock something over or pick a fight and ruin it for everyone. And what if spillover from deleveraging measures in China gatecrashes the festivities? Or any other number of events that could crop up without warning?
Those issuers with the shortest history in the markets, if they survive, will end up paying the biggest premiums. Meanwhile, investors will sober up rapidly, take a look at the label of whatever it is they have been drinking and bin it — or risk becoming very ill indeed.