It is little wonder private equity firms are among the most optimistic players in the leveraged finance market about the 2019 season. They have been having everything their own way.
Borrowers in Europe raised more than €140bn of leveraged loans and high yield bonds in the first three quarters of 2018, Moody’s data show, tracking closely the €160bn in the same period of 2017.
But issuance has become markedly more adventurous. In the first nine months of 2017, less than a quarter of the new debt — €33bn of loans and €4.4bn of bonds — was for buy-outs or mergers and acquisitions. Refinancings of old debt predominated. The M&A share for the same period in 2018 was almost double, with €54bn of loans and €10bn of bonds — 61% and 17% of issuance in each market.
“We are very sensitive to where we are in the cycle and scrutinise carefully the market,” says Peter Cirenza, the former Goldman Sachs partner who is Tikehau Capital’s co-head of private equity and head of its UK branch.
But although Tikehau, like all players in leveraged finance, is on watch for a downturn, the firm remains “very busy”, and Cirenza thinks the market will continue to run strongly in 2019.
“At this stage of the cycle, you really want businesses that have growth which is not highly correlated with broader economic activity, so that there is some underlying quality of the business that can provide revenue into the future,” Cirenza says.
PE firms believe they can still find such opportunities, and are acting on them. Tikehau invested €114m in May for a minority stake in Nexteam, a French supplier of complex parts for the aerospace industry, and in October, together with Bpifrance, put €150m into GreenYellow, the energy efficiency and solar power contractor founded by Casino.
Grey clouds, occasionally
At the bigger end of the scale, new LBOs are generating some of the largest leveraged financings in the euro market, such as the €1.3bn bond for CVC’s acquisition of the family holding company of Italian pharmaceuticals firm Recordati in October.
This unusual deal illustrates the way PE firms are departing from conventional deal structures. CVC is buying a 51.8% stake in the company, which will remain publicly listed with a €5.9bn market cap. The founding family receives part of the payment as a deferred, subordinated long-term debt security of €750m.
Even bigger was AkzoNobel’s sale of its speciality chemicals business for an enterprise value of €10.1bn, to the Carlyle Group and Singapore government fund GIC. Having sat on the bridge financing since March, global co-ordinators Barclays, HSBC and JP Morgan put the deal into the market in August as a $4.34bn and €1.79bn term loan ‘B’.
Tanneguy de Carné, global head of high yield capital markets at Société Générale in London, believes demand to issue leveraged debt should be buoyant again in 2019, particularly in the loan market, as sponsors have made it their preferred senior secured instrument.
But PE firms and companies may not find investment banks quite so eager to serve them as they have been used to. “As markets continue to be volatile and with grey skies over the horizon, we expect competition among banks will reduce, as underwriting highly leveraged credits will become more challenging,” says de Carné. “General consensus is that we are late in the economic cycle, hence banks will naturally edge further on the side of caution.”
Despite the widespread sense that the cycle is nearing its end, investors are still swallowing the very aggressive covenant terms sponsors are demanding. Specialists do detect, however, that this deal thirst is becoming more intermittent. “We are likely to see a more balanced approach in 2019, as banks also need to reflect investors’ concerns, as well as their requests for higher returns,” says de Carné. “We have started to see pushback on terms and covenants for longer periods in 2018 than in the last two or three years.”
But investors have had more success in the tug of war over pricing than on the covenant front. Euro high yield spreads have increased by more than 100bp since the start of 2018, according to SG research.
“We are now entering the inflection point, where corporates with short-term maturities are increasingly likely to accept higher coupons [than they were paying before],” says de Carné. “This is a new phenomenon we have not seen in Europe since 2007. Some corporates are still adjusting to this new state of play.”
Treasurers will have to think carefully about their financing plans, as the medium-term outlook is that coupons will continue to increase.
“Fortunately,” says de Carné, “issuers still have another couple of years ahead to continue to benefit from historically low funding costs.”
Despite these hints of the market becoming slightly less of a paradise for borrowers, the issuer side still emphatically has the whip hand.
“With demand strong for leveraged finance, it is really the supply side that will dictate leverage, pricing and terms,” says Callum Bell, head of corporate and acquisition finance at Investec in London.
In his opinion, a “much more serious market jolt” is required to undo the upward creep of leverage and the erosion of terms investors have accepted over the past few years.
“The fable of boiling a frog comes to mind,” Bell says. “The heat is quite high as we speak, but it’s hard for investors to call boiling point except in review [of the portfolio]. If they start to worry now, it is probably too late.”
Investors have, with open eyes, bought assets that are overwhelmingly covenant-lite. Any problems are likely to be detected once the loans are in the portfolio, by which time at least some pain will be unavoidable.
Of the €90bn of euro leveraged loans raised during the first nine months of 2018, 76% were cov-lite, according to Moody’s. A further 20% retained one maintenance covenant, and a mere 4% had two. Deals with a full suite of covenants are nowhere to be seen, even though they were present on 50% of leveraged loan deals in 2013, and still 17% only three years ago. Europe’s new issuance is now in line with the $1.1tr total loan stock in the US, where 80% is cov-lite, almost three times the level before 2008, according to the IMF.
Refinitiv not only went cov-lite but did away with financial performance tests for dividend distribution baskets when it raised $10bn of loans and $4.25bn of bonds in dollars and euros in September.
“Most worries will come when there is a significant market correction and pricing moves adversely in the secondary market,” Bell predicts. “The loan market is relatively illiquid. There have been enough warning signals around the asset class that you would hope this is being factored in by portfolio managers.”
Cool off, levfin
Cirenza expects to see some corpses. “There probably are some deals investors have subscribed recently, and will come to regret,” he says. “People focused on creating long-term value, instead of riding the cycle, will come off it in a better position.”
Yet optimists believe that in aggregate, the market will self-correct, a process they think will begin in 2019. If Moody’s is right to forecast that defaults in Europe will stay below 2% for the year, then investors may have some breathing space in which to tighten their terms.
“The markets will be coming off their highs of the last two years,” says Sandra Veseli, managing director of EMEA corporate finance at Moody’s in London. “It is difficult to predict a shift, but the notion that short-term interest rates will go up in Europe, and some signs of economic slowdown, are starting to affect the strategies of investors and issuers.”
Some investors are becoming more selective. Others are simply withdrawing from the market, like those who took €6bn out of European retail high yield funds during the first three quarters of 2018, according to JP Morgan.
“For some issuers, particularly those past peak growth, funding has been very affordable, but that will change in the coming years,” says Veseli. “However, there is no immediate concern over the refinancing wall.”
The same again
JP Morgan reckons gross and net issuance will differ only a little from 2018. The fall would be, for high yield, from €62bn and €19bn in the first 10 months of 2018 to €60bn and €15bn in 2019, and for leveraged loans from €71bn and €33bn to €70bn and €30bn. The tricky spot will still be the growing mountain of debt issued with very loose covenants.
“Can the convergence on covenants in the leveraged loan and high yield bond market go further, towards more flexibility for issuers?” sayswonders Veseli. “Covenants are already weak, and changes around options to take cash out of the business, confusing definitions of Ebitda and lack of deleverage are not helpful. Risks persist, and there will be more episodes of volatility in the new year, but nothing has derailed the markets in recent months.”
The new year is likely to have the vigorous action of recent years, but with a sharper sense that issuers have to give something back if they want to keep prising out covenants.
“The main assumption is that there will be a familiar pattern of undersupply and strong demand in the European leveraged finance market, with loan issuance once more ahead of bonds,” says Richard Etheridge, associate managing director of EMEA corporate finance at Moody’s. Yet there may be a silver lining.
“Sponsors are getting away with more flexible documentation than ever, although many of them are injecting higher levels of equity.”