Secondary’s riches should salvage battered levfin market
The loan market last year was hit by the double whammy of wider market turmoil and, particularly in the leveraged loan market, the death of its major investor class CLOs. The primary loan market looks like it will be moribund for several months to come, as banks are unwilling, and often unable, to lend in large quantities. The secondary market has also been hit by a lack of liquidity, although this could be its saving grace as it attracts new money from investors that want equity-like returns and an illiquidity premium.
"The problem faced right now is that there arent many functioning banks and functioning funds," says John Foy, head of leveraged finance at Prudential M&G in London.
The collapse of Lehman Brothers in September desiccated liquidity for all but a few capital market instruments, although support packages from the European Central Bank, and the US and UK governments have helped to keep banks functioning just.
"The loan market is representative of a much higher and more significant problem shaking the whole financing market," says Marco Antonio Achón, global head of loan markets at Santander in Madrid. "There is a healing process by which banks are deleveraging their bloated balance sheets. Banks are now trying to cope as best they can with new regulation and new owners, and the loan market is not going to take off meaningfully in 2009."
This lack of liquidity affects the primary loan market in two ways: banks are unwilling or unable to lend money in large amounts for buy-outs or acquisitions, and heavily indebted companies will find it more expensive to refinance. For banks that will mean clubbing together on deals, rather than syndicating. Any borrower that requires syndication of the financing backing a leveraged buy-out would probably be confronted with a request for fees at least 1% higher than for a club deal, because of the perceived riskiness involved in such a leveraged deal.
"It will depend very much on the use of proceeds," says Achón. "For refinancing of money that is already there, it will be relatively straightforward. For an acquisition, if the deal size is below Eu2bn, then it could be reasonably clubbed, but when we get beyond that amount then it is complicated."
Moodys expects companies with a weaker credit profile to find it difficult to get support from their banks when outstanding facilities mature. Companies like this will also have fewer attractive alternatives in the wider capital markets in 2009.
"Were focusing on how companies are positioned if theyre finding it difficult to refinance," says Chetan Modi, senior credit officer in corporate finance at Moodys in London.
Another issue for the leveraged loan market is that the banks that have been bailed out by the UK Treasury might face pressure from government to avoid aggressive lending, such as leveraged finance. Market participants are also worried that the government will not support lending to companies outside the UK, and so the European loan market could become much more parochial.
"I do think it will be an important trend and I have no idea where it will lead," says Jon Moulton, chairman and founder of private equity company Alchemy Partners. "If it gets too far it could seriously distort the economy. In the 1970s the government was pumping money into things like union-led co-operatives because they were politically popular. Of course all that money was lost."
Private equity companies, as well, are going to experience funding problems. While for the moment they have cash locked up Moulton estimates that, in real terms, there is around 1.5 times as much money committed to funds as was spent in the 2006-2007 private equity binge this will not go so far as there will be less debt available and returns from deals in 2006 and 2007 are going to be quite poor. Investors may therefore turn away from private equity.
According to a recent structured credit strategy report by Royal Bank of Scotland, leveraged loan issuance this year will be perhaps higher than in 2008, when the market suffered such unprecedented dislocation, but much lower than in 2006, and deals will be much smaller.
One big problem is that the secondary market is distressed and the primary market cannot compete with its pricing. In October the secondary market suffered a body-blow when defaulted Icelandic banks total return swap (TRS) programmes unwound and hedge funds offloaded their positions. But the flood of bids wanted in competition a combination of total return swap programmes and old loan warehouses is not over. Royal Bank of Scotland declared two lists of bids wanted in competition (BWICs) in November and RBS analysts in the structured credit strategy report believe that, anecdotally, less than half of all leveraged loan total return swaps have been unwound.
So just what went wrong?
The leveraged loan market, in particular, was hit by the absence of collateralised loan obligations last year. In 2007, over 50% of the European loan markets investors were institutional investors, and over 60% of that figure were managers of collateralised debt obligations. In 2003, under 25% of investors were institutional investors, and nearly 75% were European banks.
CLOs securitisations of leveraged loans which arbitrage the difference in the price of the assets purchased, and the liabilities issued were no longer possible as the price of the liabilities ballooned in a market spooked by all forms of CDO or securitisation. In early December 2008, spreads on secondary triple-A CLOs were as wide as 400bp.
Before the US subprime mortgage crisis hit, it was common for banks to warehouse portfolios of loans to turn into CLOs a process which could take six to nine months. When the crisis hit the European CLO market, these loans could not be sold in CLO form. CLO spreads shot out and the debt that the CLO issued would have been too costly for the arbitrage to work.
A distressed secondary loan market has hurt banks further as these loan warehouses had to be marked to increasingly low values.
The amendments to accounting rule IAS 39 has enabled Eu15bn-Eu20bn of loans previously held for sale on banks trading books to move on to the banking books, which will free up capital as the assets no longer have to be marked to market, say RBS analysts.
One thing that may help to ease liquidity and the new capital requirements for banks is that they have been let off the hook on commitments to some vast, potentially expensive loans. When BHP Billiton abandoned its bid for Rio Tinto in November, which had a $55bn syndicated loan attached to it, bankers breathed a deep sigh of relief. Likewise, the C$34.8bn ($28.3bn) leveraged buy-out of Canadian telecoms company BCE has been abandoned.
Secondary opportunitiesThe discounted pricing in the secondary market is promising to be very attractive to new investors that want equity-like returns on names which are distressed due to technicals and which also give a liquidity premium. These new investors are interested in unlevered and very lightly levered exposure to the leveraged loan market.
"Investors, particularly institutional investors, are starting to show a real interest in the asset class and the returns available," says Julian Green at Henderson Global Investors in London. "We have had great success in attracting unlevered money into the loan space and are talking to a number of other investors who are looking to invest in a similar manner," adds Prudential M&Gs Foy. "Investors should achieve equity-like returns for senior secured risk even allowing for lower recovery rates and higher default rates."
Both Green and Foy manage funds that investors can come into in small (£1m or under) or large (£50m or more) amounts. Another CLO manager reported in November receiving several mandates of around Eu100m from US pension funds, although this amount remains rare. Because loans are illiquid and not everyone can trade them, it is easier for an investor to place money with a fund with exposure to multiple names rather than have its own mandate unless it is investing substantial amounts of around Eu100m.
"Say there are 200 names that you could buy," says Green. "You probably want a minimum of 50-70 to achieve prudent diversification. A manager needs to exercise judgement in blending both risk and return in a portfolio and market price isnt currently an absolute indicator of quality."
Fund managers are also reporting interest from high net worth individuals. Pension funds from Scandinavia, Europe, the UK and Asia are also interested in the European market, say loan fund managers.
"Pension funds tend to invest for the long term," says Hendersons Green. "This longer term view allows them to take advantage of the illiquidity premium available in a number of asset classes, particularly loans."
But, in spite of all the noise, no heavy buying has yet been seen. Investors are waiting until January and beyond for more visibility as credit selection will be paramount they want to see fourth quarter reports, how retailers have fared during Christmas and other indicators of health. Also, market participants want to see some stability in the secondary market. "Nobody wants to catch a falling knife," is a popular phrase among loan traders.
"Investors are cautiously viewing the market as at or near bottom," says Green. "People want more visibility though. Over the last year the quarter ends have been interesting times, particularly as hedge funds have often had to react quickly to redemptions by selling assets, including loans."
Market players are conscious that they will have to get investors comfortable with a tougher economic world. Some, such as the more forward-looking pension funds, will have been burnt by the financial crisis and will be wary about putting cash to work.
"Sectors people will avoid will be those that historically have been more volatile, like retail, or service-related industries," says Green. "Utility companies like the telcos have held their prices better. But from an opposite point of view, it could be that much of the upside has been taken out compared with the cyclical companies that were trading in the mid-60s."