Evolution of the buy-side
Behind much of the growth of the European leveraged finance market over the past few years has been the emergence of an increasingly influential, relative value investor base that is willing and able to participate across a broad range of asset classes. In that respect, says Leland Hart, executive director in the leveraged capital markets group at Lehman Brothers in London, the European investor base is looking more similar to its counterpart in the US, where institutions have historically dominated primary and secondary activity in the bond and loan markets alike.
That model was quite different in Europe, where historically the leveraged loan market has been dominated by banks. That in turn has historically meant that the European loan market was much less liquid than the US market on a secondary basis.
"Over the last year or so we have seen a very strong growth in the number of CDOs and CLOs targeting the European leveraged loan market," says Hart. "But we've also seen hedge funds becoming active players across the entire capital structure. Europe is therefore moving much closer to the US model, where some funds are able to buy and trade high yield bonds, senior debt, second lien, mezzanine and payment-in-kind notes. Increasingly, we're finding that we're having conversations with single investors that are looking across the entire capital structure."
That process is one that has gathered speed over the last few years. "If you wind the clock back just a couple of years, the debt markets were compartmentalised into various discrete pockets of liquidity into which you could sell the different products that were needed to finance a buy-out," says John Kelting, managing director of leveraged finance at Barclays Capital. "What has changed is that investors are increasingly buying across the risk spectrum and there has been a significant increase in the number of investors targeting leveraged deals, including CDOs and hedge funds."
A deeper high yield investor base
The result has been that individual transactions across the entire leveraged space have been able to harness the support of a much deeper and more diversified investor base than ever before, helping to create more price tension at a primary level and bolstering liquidity in secondary markets.
Take, as a striking example, the recent evolution of investor demand in the high yield bond market, which has been revolutionised in the last five years. "Back in the late 1990s we were selling high yield bonds in the primary market with as few as 40 investors in the book," says Paul Simpkin, managing director of global fixed income credit markets at Citigroup in London. "Today we would sometimes have 200 or more."
That development has meant that new issues are no longer dependent on the support of a very concentrated handful of unduly influential accounts, as they were five or six years ago, which more often than not were specialist US players. "At the end of the 1990s the market was dominated by US funds active in Europe," adds Michael Brennen, managing director of global fixed income credit markets at Citigroup in London. "By 2000, that investor base was growing rapidly, with long-only European fund managers moving down the credit curve and playing in the high yield space for the first time."
With that investor base now also supplemented by hedge funds, a handful of investment grade accounts in search of yield kickers and — in the case of transactions such as last year's deal for the German tour operator Tui — retail investors, the high yield market is supported by a highly diverse spectrum of buyers.
That support has also become considerably more diversified from a geographical standpoint. "The UK investor base is still the main driver of demand," says Brennen, "but there are also 10-12 very large institutions in France that are now active in the high yield market, as well as a number of major accounts in Germany and Switzerland."
So much for the good news on the investor base that now supports the European high yield market. The less positive news is that much of the new investment that has come into the market in the last two to three years is not necessarily going to remain faithful to high yield.
"One of our concerns moving into 2005 is the current make up of the investor base in the European high yield market," noted Citigroup in a research bulletin published in January. This estimated that about 15% of investors in the asset class were from convertible arbitrage desks looking for returns while volatility was low. A further 10% was accounted for by correlation desks, while an additional 15% was made up of pure hedge funds, only about half of which — according to the Citi analysis — will be long term high yield investors.
"We therefore conclude that around one-third of the money invested in high yield is unstable," warned the report. "Partly offsetting this, we are likely to see some new life and pension allocations to high yield as it develops a track record of more predictable performance, though this looks unlikely to total more than Eu5bn-Eu10bn a year in the near term."
US investors targeting Europe
For the broader leveraged market in Europe, however, the general trend is one of more investors coming to the party, with the recent launch of a number of US CLOs and CDOs specifically targeting the European market.
Although these may find the operating and regulatory environment in Europe quite different to what they are accustomed to in the US, their arrival is welcomed by European investors. "Europe is more of a clubby market than the US and bankruptcy regimes are very different, so it might take a while for some of the newer funds to adjust to the European market, but in general we welcome the liquidity that US CLOs will bring," says one London-based investor.
Besides, bankers argue that the European market has become increasingly homogeneous and better understood in recent years, thanks in no small measure to the work that has been done by law firms and accountants as well as investment banks throughout the continent. "So many restructurings have been in a number of different countries throughout Europe in the last three years that there is more than enough knowledge on the Street about how the various jurisdictions work," says Steve Pitts, co-head of European leveraged finance at Deutsche Bank.
ELLI trumpets arrival
Looking to the longer term, a number of recent developments in the leveraged loan space are likely to encourage still more investors to come into the market. One of those was the launch in November 2004 of the Standard & Poor's (S&P) European Leveraged Loan Index (ELLI), modelled on the ratings agency's US Loan Index, which has been published since 2000 in partnership with the Loan Syndications and Trading Association. Bankers clearly welcome the arrival of the S&P product in the European market, which is the first to be based on loans available to institutional investors, rather than banks.
As S&P explains, "using the loan portfolios of key institutional loan investor partners Alcentra Ltd, Harbourmaster Capital Management Ltd, Intermediate Capital Group, ING Capital Management and M&G Investment Management Ltd, the... ELLI series tracks the performance on leveraged loans issued to investors in the region that are now providing 20%-25% of primary market liquidity. Secondary market prices for the market value return calculations are gathered from two sources — the Loan Market Association's (LMA's) weekly valuation survey and the European pricing database of Mark-It Partners/LoanX."
The ELLI series is made up of four elements — multi-currency and euro denominated broad and LBO indices — and a snapshot of their components as of the start of February 2005 gives an indication both of the speed with which the European leveraged loan market has grown in recent years, and of how well diversified it has become.
The indexes are tracked back to the end of 2002, when they were made up of 63 facilities with a market value of just under Eu9.5bn. By February 2005, there were 167 facilities representing almost Eu24bn, of which 149 (Eu20bn) were LBOs. Some 85% of the index is euro denominated, and the largest industrial sector (cable TV) represents just 16.6%, followed by publishing (13.8%) and non-food retail (7.4%).
Initiatives such as S&P's, twinned with the promotion of efficient loan trading by the LMA, have clearly helped to boost volumes in the secondary market for leveraged loans.
S&P observed in January that there had been a brisk start to the year in the market, with trading volumes in the early part of 2005 sending bids to record levels. Since then, volumes have subsided slightly, which bankers say is probably no bad thing.
"The secondary market is not as frothy as it was a few weeks ago," says a banker in London. "That was a time when a lot of the trading activity was coming from hedge funds and CLOs with money to invest but without access to product in the primary market. As a result they were paying above par for loans which is not a clever thing to do in the loan market as there are no prepayment penalties."
Aside from enhanced liquidity in the leveraged loan market, product innovation is also encouraging more investors to step into the market for the first time. At the start of March, Alcentra unveiled Hamlet I, a lightly levered CLO. Arranged by JP Morgan, this was a Eu300m CLO which was 3.8 times levered and made up of Eu222m of triple-A rated senior loans and Eu78m in equity. "Hamlet was designed as a way of giving more conservative investors, principally pension funds, the chance to gain exposure to the European leveraged loan market," says David Forbes-Nixon, Alcentra's chief investment officer. "It was an interesting development because it brought a lot of new investors into the market, so we would expect to see more of these transactions in the future."
Another more recent development that is seen as highly positive in terms of enticing more investors into the leveraged loan market has been Morgan Stanley's recently unveiled plans to offer callable credit default swaps (CDS) referencing European leveraged loans. "The proof of the pudding on the Morgan Stanley CDS initiative has yet to be eaten," says one banker. "It is a very welcome initiative but it all depends on how many names they will genuinely make a market in. You could argue that if they only concentrate on the most liquid names they will only be replicating the hedging opportunities that are already available in the secondary market. But it is a smart idea and another facet to a maturing market."