While the plain vanilla loan market continues to suffer from low volumes and low margins, the leveraged loan business is booming. Records continue to be broken, new structures continue to be forged and new investors are coming into the market. Taron Wade reports on the most impressive segment of the Euroloan industry.
Last year was a landmark year for leveraged loans as the market absorbed $34bn in debt, raising the question of whether 2003 would compare in deal flow.
Thus far, 2003 has not disappointed, with $31.7bn in transactions year to date, including the record Eu5.7bn buy-out of Seat Pagine Gialle's directories business comprising Eu3.2bn in senior debt.
"We have seen another very, very strong year. Deal flow has been as good as last year in both the number of transactions and in debt volume," says Paul McKenna, managing director and head of leveraged syndicated finance at ING in London. He expects deal volume this year to outstrip 2002.
But at the same time as the market continues to pump out record breaking deals, there is a stalemate over margins. Pricing and fees remain stagnant and yet more banks are trying to win lead arranging roles, leaving those banks at the top with a smaller piece of the pie.
This has left many wondering if and when conditions will change.
"In a thin market, competition for mandates is keeping gross fee levels static, but lead arrangers are having to pay more away to de-risk," says Jonathan MacDonald, managing director and head of loan syndicate at UBS for Europe and Asia in London. "At the same time, structural terms are being pushed. No doubt, most deals are still selling but the net effect is lead underwriters are being paid less to take more risk."
It is well known that pricing is not the selling point of deals in Europe. But in the US, where institutional investors provide around 80% of liquidity, a buyer will usually step in as long as there is compensation for the risk. For example, in the buy-out of Levi's in the US senior debt investors were offered Libor plus 750bp (which was subsequently flexed down to Libor plus 687.5bp). Because banks - which still dominate the European market - are less focused on risk versus return they would typically avoid such a deal.
"The European market is binary - either deals get done or they don't," says David Forbes-Nixon, chief investment officer and head of European operations at the Alcentra Group, the leveraged loan asset management shop formed last year by equity asset advisory group Alchemy Partners through the acquisition of Imperial Credit Asset managers from Imperial Credit Industries, a California fiancial services group.
"Institutional investors are better at assessing risk versus return whereas the banks have a fairly rigid credit process, more of a 'do we think we will get our money back?' approach, rather than 'are we being adequately compensated for the risk we are taking?'" He adds that some banks are starting to get more sophisticated about risk through portfolio management.
More investors needed
Bankers agree that pricing will not change until institutional investors represent 40%-50% of the market. They now comprise about 20% of the European market and most bankers say that this percentage will not change substantially until there is further bank consolidation, which is made difficult by all the different tax laws and regulations within the European Community. And on the other side of the equation, collateralised debt funds continue to struggle to raise funds which is also hampering the growth of the institutional market.
"Growth in availability of funds in the institutional market has been slowing for some funds and is on a plateau for others with some managers having to recycle positions to finance new investments," says David Wilmot, director at Duke Street Capital. "In our case, we are able to deal in size and have a good relationship with arrangers and investors, but issuance conditions for some CDO managers are tough. Quite possibly some investors have been conditioned by uncomfortable rides in funds covering different asset classes such as telco and investment grade."
There is also the ramp up risk of CDOs, since they are launched at less than 100% invested and are therefore influenced by how quickly they can be invested.
Wilmot suggests that some non-bank investors are thinking about raising funds to invest in senior leveraged loans through investment vehicles other than a CDO - similar to being a straight money manager because leverage is not used.
Prudential M&G has started doing just that for external pension funds. The money manager has been investing capital from its life funds in such a way since 1999, but last month launched a new business line in which it builds and manages leveraged loan funds for clients. Shell Pensioenfonds, the Dutch pension fund of the Anglo-Dutch oil company, has already chosen Prudential to manage Eu50m of leveraged loans. This first fund, which does not use leverage, will make direct investments in loans through a segregated account.
The growth of new investment vehicles could eventually filter into the market to change price. But it is also the development of the secondary trading market that will influence margin changes. The more liquidity that is developed in that market, the more that pricing will become a measure of the risk/return trade-off. "The European secondary market for leveraged loans has almost doubled in size this year, which is a very important development," says Alcentra's Forbes-Nixon.
It is in structure, however, that deals are differentiated in Europe. And underwriters are not only settling for a smaller piece of the larger pie. Covenants are being relaxed on many deals as well, bankers say. For example, it is becoming the market norm to exclude conditionality in the underwriting - typically through eliminating the material adverse charge clause (MAC). The headroom on interest cover is being relaxed as well, which is giving companies what many consider as too much leeway.
Levels of leverage are also a moving target on deals. "Leverage has been increasing because of increased competition between arrangers," says Duke Street's Wilmot. "We have turned down some deals for high quality businesses but where in our opinion, the leverage left insufficient margin for error." David Yeoman, head of leveraged finance syndications at Royal Bank of Scotland in London, says: "Structures are becoming more aggressive, evidenced by the fact that deals where equity composes less than 30% of a deal are becoming more common." Andrew Phillips, director at ICG in London, agrees that leverage multiples are high. "It is time to be careful," he warns, but points out that interest rates are low, so the overall debt burden is not much higher than in the past.
At the same time as leverage climbs higher, investors are becoming more focused on individual buy-outs. "They are more willing to consider a deal on its merits rather than be put off by the headline numbers," RBS's Yeoman says.
Most of these changes are a direct result of an increase in competition. In general, banks have ramped up their leveraged finance groups in an effort to move up the foodchain and become not just participants, but mandated lead arrangers.
Additionally, many are worried about the manner in which deals are being syndicated and feel some lead managers are not using a proper syndication process. Increasingly, sub-underwriters are ringing around others before committing and this is creating a situation where no one wants to jump in to a deal first.
Bankers say this will not change until there is a big blow-up, where a bank without the necessary syndication skills underwrites a large transaction and becomes stuck in selldown.
Also, because of the increase in the number of lead arrangers winning deals, banks are making less money from fees since the pool is smaller and fixed costs from selling a deal have not decreased. It has taken the better part of two years to see larger groups of mandated lead arrangers translating into higher arranging fees. For example, arranger fees on senior debt are typically 225bp whereas a couple of years ago the fee was around 220bp.
Coupled with this, many arranging bankers feel that sub-underwriters are skimming off too large a portion of these fees. "Personally, I think sub-underwriting fees have gotten out of hand - unless, of course, I am wearing my sub-underwriter hat," says ING's McKenna.
Second time around
Although the market has been busy this year, much of the activity has been generated through secondary buy-outs and recapitalisations.
"This has resulted in some recycling of existing assets which, despite the nominal increase in primary volumes, is one of the reasons why liquidity has remained so strong," says Richard Howell, head of leveraged capital markets at Lehman Brothers in London. "Many private equity sponsors are under pressure to realise gains in their portfolios in order to have a good story to spin when they are out on the road raising funds."
ING's McKenna speculates that since the first quarter was relatively quiet, banks went out and pitched these ideas to generate business. "It's been quite successful," he says. "As the share of the fee cake is being reduced, arrangers increasingly pore over portfolios to generate their own deals."
Citigroup's head of leveraged syndicate Jeff Knowles adds that these transactions are also easier to execute than a new LBO since investors already know the deal. "People like a proven borrower," he says.
These types of deals also indicate that there are few exit options available to financial sponsors. However, low interest rates, low credit losses and an improving equity market are also helping to encourage both financial sponsors and companies to structure deals.
Acordis, Aviagen, CEVA Animal Health, FL Selenia, Focus Wickes, Jessops, Materis and Nycomed are all secondary buy-outs which were launched this year.
The market did not see as many billion dollar transactions as last year, but some bankers are happy that this autumn has not had as many scheduling problems. Bankers commented that this time last year it was difficult to get investors to look at deals because they were inundated and bank meetings even had to be reshuffled.
But 2003 has included some prominent transactions, including the largest LBO the European market has ever seen, the Eu5.7bn buy-out of the directories business of Seat Pagine Gialle. There has been much debate over whether the market has the liquidity to absorb the Eu3.2bn of senior debt on the deal. Sub-underwriting tickets of Eu250m a piece with target take and hold levels at Eu100m are tough by anyone's standards, leaving many to wonder if sub-underwriters would be able to reach their take and hold levels. In fact Barclays, BNP Paribas, Credit Suisse First Boston and Royal Bank of Scotland were able to secure 17 sub-underwriting banks at the senior stage - a storming success. Mandated lead arrangers are still waiting for commitments at the retail stage.
The second largest deal was also an Italian one - the LBO of Fiat Avio by the Carlyle Group and Italian company Finmeccanica Fiat Avio. This Eu925m facility had an oversubscription of 30% and therefore did not proceed into general syndication.
The buy-out of BertelsmannSpringer, which also includes a refinancing of the buy-out of Kluwer Academic Publishing from Wolters Kluwer, was another deal that stood out. The Eu810m in syndicated debt had a 70% hit rate and had a mix of US and European institutional investors participating - an unusual result for a European buy-out.
The deal, which also funds the formation of a new company, Springer, consists of Eu265m in mezzanine debt, which was the second largest mezzanine tranche so far this year.
The future of upstream guarantees
The Seat Pagine Gialle buy-out was also notable in that it includes upstream guarantees for high yield bondholders. Earlier this year, there was high profile resistance from senior debt investors during the execution of high yield bridge take-outs in the buy-outs of Legrand and Brake Brothers. Mandated lead arrangers tried to push through waivers that would allow these guarantees on the two transactions and were met with much resistance, especially since the senior lenders were approached after the deals had been signed.
The future of upstream guarantees is still unclear. Some bankers believe that senior lenders are getting more comfortable with them, and otherwise they would not have been included on the Seat buy-out. Lead managers said there are upstream guarantees for high yield bondholders in place for when the Eu1.15bn subordinated bridge facility is taken out by a high yield bond offering in 2004 and that the structure was one both senior debt lenders and high yield bond holders could agree on. They would not disclose specifics on the structure, however.
Others do not think the issue has been put to bed yet. "I think upstream guarantees are fine when structured correctly, but there are still limited precedents," says Jeff Knowles at Citigroup.
"Market opinions are mixed on upstream guarantees, but the devil is in the detail," says Duke Street's Wilmot. "If high yield is getting real security, and enjoys enhanced rights in the case of a covenant breach, this changes the balance of power between creditors and is problematic for senior lenders."
Banks and institutional investors are still resistant to giving high yield investors that security, says Alcentra's Forbes-Nixon. "It will be on a case-by-case basis and senior loan investors will need to be compensated for any additional risk through the pricing and structure of their loans," he adds.