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The Societe Generale Cross-Over Credits Roundtable

13 Jan 2006

Over the last 18-24 months a new segment has developed in the loan and bond markets, now known as the cross-over space. A growing number of bankers recognise that in a market in which yield is increasingly elusive, this is an area that they can ill afford to overlook. All the more so, given many bankers' belief that the cross-over market can provide yield pick-up blended with low and manageable risk.

In the Société Générale Corporate & Investment Banking Roundtable on Cross-Over Credits, the following panellists discuss the emergence and likely evolution of this poorly understood but growing and potentially very rewarding stratum of the capital market:

Stephen Swift, head of European loan syndication at Société Générale

Chris Baines, head of European loan distribution at Société Générale
Tanneguy de Carne, head of European high yield at Société Générale
Françoise Cambilargiu, group treasurer of Rémy Cointreau in Paris
Anthony Leech, assistant senior manager, syndicated loans, Norinchukin Bank in London
Francis Neo, vice president and team head of leveraged finance, UOB, London branch
Paul Watters, director in the leveraged finance group, Standard & Poor's, London.
Philip Moore, EuroWeek contributing editor and roundtable moderator

EuroWeek:Given that there are so many differing views on the subject, perhaps we should begin by defining what we mean by a cross-over credit?

Swift, Société Générale: We believe there is a wide range of possible definitions. One would be a non-investment grade corporate loan which could be either rated or unrated but which is not classified as a leveraged loan. The problem with that definition is that there are some companies that always have been and will always remain non-investment grade, because of the structure of their balance sheet.

The notion of a cross-over credit, however, implies a certain degree of movement, with companies' credit profiles changing as they deleverage and move back up through the credit spectrum.

Another category of cross-over credits are the so-called fallen angels that have moved from investment grade to speculative grade and are now moving back up the ratings scale — so there may be a brief cross-over opportunity there.

Watters, S&P: We would think of cross-overs as strong double-B credits, which would suggest pricing below the standard LBO market, so we are probably talking about a pricing range of somewhere between Libor plus 125bp and 225bp.

Leech, Norinchukin Bank: From our point of view, a cross-over credit would generally be an unrated mid-cap UK or European corporate.

With Basel II coming we would of course rate companies internally, with most of the companies we would categorise as being cross-over names internally rated in the BB or BB+ area. We tend to look at those names rather than at fallen angels, where facilities tend to be undrawn in any case.

Swift: I would agree that fallen angels are perhaps not the best examples of cross-over credits because they will generally tend to retain their existing banking relations and banking facilities, keeping many of the corporate-style features of those facilities including a certain pricing discount.

Baines: Clearly, the definition of a cross-over credit is probably the most difficult thing to agree about, because by definition there is no definition!

Some people will base their definition on yield, some on rating and some on structure. A cross-over deal could be a project financing with a shorter maturity than usual — in other words, an unusual refinancing risk. It could be a structured transaction with very appealing underlying strengths but with weaker than normal security. For example, it may have very strong and visible recurring cashflows which justify weaker security.

The common theme would seem to be that these deals still make a lot of sense for lenders on a risk-adjusted basis, but they don't fit into conventional bank silos, or tick the usual boxes in terms of security or yield or both.

EuroWeek:Would others agree that project finance and other infrastructure financings qualify as cross-over credits?

Watters: Some of the European toll road deals may look like investment grade transactions in terms of their pricing, but given their structure and leverage some of them may fall into the cross-over space.

Baines: In some cases you can also put telecoms financing into the cross-over category.

For example, some of the names that were Ebitda negative a few years ago are starting to generate cashflow. That means that it is easier to take a view on the credit quality of a number of the cable and telecom companies.

As a consequence the premium that investors demand for these credits has fallen and the structures of their deals have become a little less demanding, helping them move from the leveraged universe to the cross-over space.

But lenders will look at these credits very much on a case-by-case basis, and the same is true for many of the deals in the infrastructure arena — which brings us back to the problem of definition.

EuroWeek:There is nothing fundamentally new about cross-over credits, is there? There must always have been companies that inhabited the poorly defined space below investment grade land. How were those credits handled before the market started talking about cross-over credits?

Baines: Cross-over credits have always been there. But in the past they raised smaller amounts and tended to do so in club or bilateral facilities. It is only in recent years that they have become more visible in the syndicated loan market.

EuroWeek:So the emergence of the cross-over market is symptomatic of the broadening and deepening of the syndicated loan market?

Baines: Exactly.

Leech: I would agree that this is not a new segment of the market. It just happens to be receiving a lot more publicity these days because, as we see it, the leveraged market has been shunted down into the single-B area, leaving a big gap.

In the US the leveraged market tends to be rated in the double-B area, which we would see more as the province of cross-overs.

Swift: I think it is right to say that there has been a shift in the way banks handle credits in different ratings brackets.

A few years ago triple-B borrowers were probably seen as being outside the core investment grade world, which was populated by single or double-A borrowers. In the last three or four years banks have moved down the credit curve, so the triple-B names and even some of the stronger BB+ credits are being handled as investment grade firms.

At the same time, structures have been stretched quite significantly in the leveraged loan market, where we've seen a decline in the average rating and credit quality.

What is left is a vacuum that sits in the middle, and although it has always been there, banks have been more ready to service it because they have moved down the credit curve.

Baines: Yes. And one of the reasons explaining this development is that banks' credit analysis skills have improved enormously over the last two or three years. Banks' ability to take a much more analytical view of credit has helped underpin the growth in liquidity in the cross-over space.

EuroWeek: What are the main structural features of a typical cross-over loan?

Swift: The basic characteristics of these deals would be that they are medium term facilities with a single bullet tranche or limited amortisation, with maturities of up to five or seven years.

They will also generally be unsecured deals or facilities with a security package that would be released in line with the activation of certain trigger points.

EuroWeek: Looking at demand in the market, what are the principal attractions of the cross-over market for banks?

Neo, UOB: We have been attracted to the cross-over space by the yield. Over recent years we have seen the asset swap spread on BBB+ bonds dry up. Some 18-24 months ago we could expect to be paid between 125bp and 150bp over Libor for a BBB+ credit. Nowadays I think we would be lucky to get between 50bp and 75bp.

So for capital adequacy reasons we moved into the leveraged loan market, but we would also see cross-overs as part of that move into higher yielding assets.

Leech: We have had a similar experience. For us the triple-B investment grade area has become a virtual no-go area because there is just no return there.

We have a fairly broad investment strategy, and we see the cross-over market as one that fills a niche by providing a little more return without exposing us to the sort of risk that you would see in the leveraged loan market.

Swift: I would agree that yield is a key consideration when defining what we mean by cross-over credits, which is perhaps another reason why some of the fallen angels would be less attractive to lenders in this space.

Baines: In the investment grade arena even jumbo acquisition facilities no longer offer the same sort of attractive premiums that they used to. Of course they are priced above benchmarks, but the benchmark pricing has fallen so far that in absolute terms the pricing of acquisition facilities is lower than ever.

That is one more reason why banks are looking to go down the credit curve. 100bp over Libor may be the minimum that many are looking for in the cross-over market, but pricing is so low in the investment grade world that I suspect some would be happy with 75bp to 80bp.

EuroWeek:Has supply of paper also been a problem for lenders?

Leech: Yes. The loan market statistics would suggest that 2005 was a bumper year, but it has only been a bumper year for the leveraged loan market. The investment grade market has been virtually dead as far as we are concerned.

It has almost all been refinancings and in the last year about 85% or 90% of the market for investment grade refinancings in Europe has been accounted for by undrawn facilities.

That is forcing many banks down the credit curve.

EuroWeek:At the Norinchukin Bank in London, what is your exposure to the cross-over market? What sort of returns are you looking for in the cross-over market, and what situations are most likely to deliver those returns?

Leech: The cross-over area represents anywhere between 10% and 20% of our total portfolio, so it is certainly not an insignificant amount.

As far as pricing is concerned, I think cross-overs will generally be priced at between 80bp and 150bp over Libor, but we would typically be looking for credits paying at least 100bp — better than investment grade but below the leveraged market.

We have found that that sort of return is often paid by medium sized, unrated companies making fairly major acquisitions.

EuroWeek:What is the size of UOB's total cross-over portfolio, and what sort of credits have you been buying in the cross-over space?

Neo: We have a sizeble loan portfolio of which about 15% is in the cross-over market.

In terms of the companies we favour, many of our investments have been in situations that were originally LBOs where the company has since gone to the stock market, efficiently deleveraged its financial structure and then gone back to the banks to refinance its debt.

Examples of those situations that we have invested in would be in the directories, restaurants and foods sectors.

They were all originally bought by private equity investors and where the financial ratios have improved to the point that they have been able to refinance their debt at around half the interest margins they were paying as LBOs. We would therefore view these names as improving credits.

EuroWeek:Would you buy into so-called fallen angels?

Neo: We have certainly looked at credits like Invensys and Ahold. Whether or not we would invest in names that used to be investment grade companies would depend very much on the timing and on the structural progress they have made in restructuring their balance sheets.

Baines: I would agree that in a number of cases being classified as a cross-over can be a good sign for a fallen angel credit, because it can act as a clear indication that the company is firmly on the road to being an investment grade credit again.

EuroWeek: So it would seem that from a business, financial and cultural perspective the various different categories of companies within the cross-over space are very different?

Watters: That is true. The credit stories are all entirely different. But that means that lenders in the market will have to develop a broad range of skill sets, allowing them to appraise very different situations.

EuroWeek:What is the attitude of companies themselves to what bankers describe as the cross-over market? Is there a perception among corporate treasurers that because there is no recognised cross-over asset class, they will have less access to funding than investment grade or clearly leveraged names?

Watters: That depends on whether you are a fallen angel or an aspiring rising star! Certainly, investment grade companies are increasingly under pressure to maximise the efficiency with which they use capital by, for example, returning surplus cash to their shareholders through share buybacks and special dividends.

Whereas investment grade companies used to aspire to ratings in the double-A area, they are now much more likely to steer their risk profile towards the triple-B area, and for many companies BBB+ is now seen as the sweet spot in terms of the most efficient balance between debt and equity. But while they will generally have no problem with coming down to BBB+, a BBB flat or BBB- rating will leave them on the cusp of investment grade and most companies are reluctant to go that far in terms of their rating.

Swift: As the cross-over market develops a demonstrable track record, companies will recognise that they can command very good terms as borrowers in the cross-over space.

We have seen a number of examples of very successful cross-over deals that have been refinancings of LBOs. I'm thinking of transactions for companies such as Legrand in France. When it recently refinanced the Eu2.2bn LBO that was originally arranged in July 2002 it put in place a corporate-style deal with very attractive corporate-style pricing.

Cambilargiu, Rémy Cointreau: At Rémy Cointreau we don't like to consider ourselves as a junk or high yield company, and I'm always careful not to use the expression "high yield" in discussions. But when we did our most recent bond issue last January we had about 25% of the final allocation sold to cross-over investors. I didn't see them as being high yield or high grade investors but as investors sitting between the two. And as far as Rémy is concerned, I believe that these were investors who were buying into the Rémy name because they saw us as a rising star, or as a company that was moving in the right direction. So in that sense there was nothing negative about being seen as a cross-over credit.

EuroWeek:So there is no longer any stigma associated with being a cross-over credit, or a borrower outside the hallowed investment grade territory?

Swift: That's right. There is no longer a pejorative tag associated with being outside the investment grade market. The capital market has developed to the point that there is a viable alternative for borrowers at every level of the credit spectrum. The bank market probably provides the greatest availability of finance across that entire spectrum because it offers solutions to borrowers from triple-C in some pockets of the leveraged space all the way up to the top ratings.

Baines: Companies have recognised that they need to be realistic. If you're a fairly small corporate making a leveraged acquisition which is going to make you comfortably sub-investment grade, and if you're not able to price and structure your deal with a strong relationship bias, you don't have much alternative to the cross-over market. That inevitably means paying up and giving lenders stronger structural controls over the life of your facility than you would give as a single-A rated firm.

I think the word we're all dancing around is stigma, and there is certainly less stigma associated with being a cross-over credit in the US than there is in Europe. Companies in the US are more comfortable with leverage, which they take on for a number of very good reasons which may be related to the cost of capital and tax efficiency.

But they are happy with being investment grade and one of the reasons is that they know that there will be access to capital markets to allow them to finance themselves efficiently. That hasn't quite happened in Europe yet, but I think we are heading in that direction.

EuroWeek:For bank lenders in the cross-over world, what is the ideal endgame in terms of the credits within their portfolio?

Leech: The endgame from our point of view is that their leverage will come down. And when leverage is reduced to the 2-1/2 or three times range they will start to look more like investment grade credits as far as our internal ratings are concerned.

Ideally, the companies we invest in will be able to generate strong cashflows to deleverage but also to make and integrate acquisitions. Pernod Ricard would be a good example of a company which has developed a tremendous record of deleveraging and integration, so that would be the sort of company we would be interested in, taking a view that it has the potential to climb back up to investment grade.

EuroWeek:In your recent experience, have things gone largely to plan? In other words, have the companies within your portfolio succeeded in deleveraging and growing as you had hoped?

Leech: The vast majority have succeeded in delivering in line with our expectations, although in some cases deleveraging may not have happened as quickly as we had hoped. To date we haven't seen the credit quality of many of these companies deteriorating, although I think we have to look at them on a case-by-case basis — depending, for example, on how well diversified they are from a geographical or product perspective.

EuroWeek: Does that mean that you have to keep an eye on many of the developments that equity investors would watch?

Leech: Yes. The spreads many of these companies command are often predicated on achieving a certain predetermined amount of growth in a given time.

Baines: In general banks in this market are looking for borrowers to generate growth which in turn generates Ebitda and reduces leverage. I wouldn't necessarily say that is an equity investor-style approach, but a risk-controlled, cashflow-based approach.

But it is important to emphasise that there should be an element of dynamism associated with cross-over credits. Companies should have a realistic growth plan or a strategy for increasing margins that would give them a good chance of deleveraging rapidly and therefore moving back up to an investment grade rating.

EuroWeek: Which companies have successfully been through those stages of development?

Baines: Even though it is an unrated credit, I would agree with Anthony [Leech] that Pernod Ricard has been a very good example of that process. When we arranged its Eu5bn facility supporting its acquisition of Seagram's spirits division in 2001, EuroWeek described the deal as a halfway house between a vanilla acquisition transaction and a highly structured leveraged financing. That was a fair description because the senior debt was six times leveraged, which has only rarely been achieved in the leveraged loan market to this day.

That facility paid 132.5bp out of the box and was a typical cross-over credit with strict borrowing restrictions and other covenants.

Since then Pernod Ricard has been through a successful asset disposal programme, which has made it a much stronger credit. Look at the pricing of its Eu9bn facility last year, supporting its acquisition of Allied Domecq, which is priced at 75bp over Libor drawn.

EuroWeek: Yes, but the success of the deal in 2001 was predicated on lenders' confidence in Pernod Ricard's asset disposal programme.

What is the relationship between risk and reward in the cross-over space? Surely there must be an element of added risk associated with buying into these credits, or else there would be no spread to investment grade paper?

Swift: If investors' credit analysis has been correct, then they should be able to extract more value out of cross-over paper than they could in the market for triple-B borrowers, without taking on an unacceptable level of risk.

That is because if you are buying into an improving credit there tends to be a time lag before any improvement is factored into public ratings.

Implicitly there is, of course, more risk in these names than there is in the lower reaches of the investment grade arena. But the pick-up in yield more than compensates for the added risk, which is why a growing number of lenders are becoming increasingly attracted by the opportunities in the cross-over market.

EuroWeek: On the subject of risk, what — if any — are the characteristics of recovery values in the cross-over market?

Watters: Again, it is dangerous to generalise too much as potential recovery values depend on the path to default and underlying value of the assets or the business if it can continue on a going-concern basis. If a performing LBO that had improved its financial risk profile then defaulted that would be unusual and unlikely to be good news from a recovery perspective.

Conversely, in the case of fallen angels that restructure and refinance their outstanding debt to take account of their new circumstances you typically find that the senior bank lenders protect themselves very efficiently. So the recovery prospects for the debt at the top of the capital structure ought to be good.

One example of that was the Recovery Rating of 2 (80%-100% expected recovery) that we assigned to the senior secured loans for Invensys in February 2004.

Perhaps the real question as far as fallen angels are concerned should focus on the recovery prospects for the subordinated lenders, which is where the real risk sits.

EuroWeek: A very conspicuous theme across the broader syndicated loan market in recent years has been the watering down or even the wholesale phasing out of covenants. Does this also apply in the cross-over market? How would you describe documentation and lender protection in the cross-over area?

Leech: Certainly a trend over the last two or three years has been the relaxation of protection afforded to lenders across the entire loan market.

That process has inevitably been driven by a combination of excess liquidity and a lack of supply, which has allowed arrangers and structurers to push pricing as well as structures within the market.

Is this a healthy development? Of course not. But I think the investor community is tending to accept weaker documentation in exchange for the returns that cross-over credits can offer them.

Swift: As far as the lending banks are concerned, documentation is probably the most difficult area to judge on cross-over deals.

As a mandated lead arranger [MLA] you have to make a call on the extent to which you can strip away the protection you would write into a pure leveraged deal while ensuring that you maintain elements of protection that you would not include in a deal for an investment grade corporate.

It is a very delicate balancing act and I think it takes a very skilled and experienced bank to manage the process efficiently and sensitively.

The problem has been exacerbated by the fact that documentation standards in the syndicated loan market have been declining now for the last three or four years. Many practitioners have yet to see a real downturn in the credit markets and are not used to structuring deals for those contexts.

EuroWeek: But would it be fair to say that documentation in cross-over land is closer to the leveraged loan market than to investment grade?

Baines: That would be one way of putting it. It is clear that there needs to be tighter borrower control and more investor protection for a double-B deal than for a single-A transaction. That may mean limitations on dividends, for example, and asset disposal clauses.

EuroWeek: How do leverage multiples in the cross-over market compare with those on leveraged loans?

Leech: Leverage multiples for cross-over credits will generally be in the range of three to four times. When you start seeing multiples over four times you are entering into leveraged loan territory.

EuroWeek: How transparent are companies in the cross-over space?

Neo: We draw a lot of comfort from the fact that in LBO situations, in particular by the time the MLAs come to look at them, companies will have been very extensively researched and have been through a thorough process of due diligence. So, in general, I would say that the transparency standards of the companies we have invested in are good.

EuroWeek: Who are the principal cross-over lenders or investors?

Leech: Generalisations are dangerous, but this is a market in which some banks are unable to play because they are either investment grade or leveraged lenders, with limited flexibility to look at anything in between.

That means that as far as lenders are concerned this is still a bit of a vacant space. Lenders in the leveraged loan market won't be attracted because it doesn't pay enough, while investment grade lenders won't be interested because this is largely sub-investment grade land and therefore off limits.

EuroWeek: Looking at the evolution of demand, are European or US institutional investors likely to become attracted to the cross-over market?

Leech: Currently the returns are just not good enough for the funds.

However, risk is increasing in the LBO market but returns are not rising commensurately as leverage levels rise and structures get stretched. Good assets will become scarcer.

Combine this with the increasing numbers of institutions leveraging up in the European market and appetite for lower yielding but lower risk cross-over credits may start to increase.

Watters: One development that we might see in the European market is that CLO investors in particular may start to adopt a barbell-type strategy.

They may start to buy some double-B cross-over names to boost the overall average ratings of their portfolios while simultaneously increasing their permitted exposure to second lien or mezzanine paper as a means of compensating for the reduced yield.

It is too much of an over-simplification to say that the spread available on cross-over deals by and of itself is too low to attract institutional investors, as it depends on their overall appetite for risk and the return they are seeking to achieve.

Baines: That is a fair comment. We are probably still some way from the funds coming into this market at 100bp or 125bp, but at 150bp they may start to take a view on a risk-adjusted basis.

The new, lower leveraged CLOs may be one example of a vehicle enabling a fund to look to the cross-over market as a way of earning less yield for less risk. Maybe in the future we will see the emergence of dedicated cross-over CLOs, or at the very least lower leveraged CLOs being more flexible and making room for cross-over exposure.

Swift: Up to now the absolute yield available on cross-over credits is such that for most traditional CDOs they have been off the radar screen. It will be interesting to see if that changes in the near future.

However, we should also remember that funds are generally looking for drawn assets and for a reasonable certainty that the asset will remain drawn over a significant period. That is precisely the opposite of what a cross-over credit is likely to offer — because by definition a cross-over credit is looking to move up through the ratings range and then benefit from being able to refinance at better rates and with more flexible structures. So the last thing a cross-over name would want would be to find itself locked into an eight year facility.

EuroWeek: Presumably the high yield bond market is the most obvious source of competition for the loan market as a funding source for cross-over credits. Has the high yield market become more receptive in recent months to borrowers from the cross-over space?

De Carne, Société Générale: Without a doubt. The continued search has brought an increasingly large number of players into the high yield market, and last year it was not unusual to see transactions substantially oversubscribed and trading very strongly in the aftermarket.

The high yield market enjoyed a record year in 2005 and the pipeline is now busier than it has ever been in the short history of the market in Europe. We are expecting transactions worth about Eu10bn to price in the first half of 2006 and we don't think there will be any shortage of demand.

EuroWeek: What competitive advantages does the high yield bond market offer over the loans market?

Cambilargiu: At Rémy Cointreau we look closely at both markets because the main question for us is not 'should we do a bond or should we do a loan', but 'which source of funding will be the most efficient for Rémy Cointreau's balance sheet as a whole?'

Of course, differences exist between the bond and the loan markets, but those differences are becoming smaller. For example, the bank market can now give longer tenors. The standard in the bank market used to be five years, but we are now able to do seven year syndicated loans without much difficulty.

From an overall cost perspective, bank loans are still less costly and as they are for the most part revolving facilities it is important to retain the flexibility that the bank market provides. But it is important to maintain an equilibrium between markets because the bond market gives corporates access to a very liquid and well diversified investor base.

De Carne: The high yield market has a number of advantages. One is that the investor base is large and well diversified and requires no maintenance of financial covenants like bank lenders in the loan market. Bond investors are generally satisfied with quarterly reports and some incurrence-based tests.

Another advantage of the high yield bond market is that corporates are attracted both to the non-amortising nature of the product and to the range and length of maturities it offers.

A third benefit that has become especially apparent in the last few months is the flexibility that the high yield market offers to borrowers in terms of allowing them to tap existing tranches of outstanding bonds. A recent example of that was when the German glass manufacturer, Gerresheimer, added Eu60m to an outstanding bond to debt finance an acquisition.

EuroWeek: So will borrowers like Rémy Cointreau make a relative value decision between tapping the bond and the loan market, or try to generate any kind of price tension between the two?

De Carne: The two markets do compete, because they are now able to price credits at virtually the same level. The main difference between the two is of course the call provisions. A seven year high yield bond for a double-B borrower will typically be non-callable for three or four years, so that may be a way in which the loan market is more flexible for borrowers.

As far as Rémy Cointreau is concerned, it is one of the best examples in the market of a company that has managed the two markets extremely efficiently.

When it returned to the bond market in June 2003 it talked to participants in both markets at the same time, and put in place a partially drawn loan facility just before coming to the bond market, which the company knew would be a positive selling factor among bond investors.

It adopted a similar strategy in January 2005, tapping the loan market for an undrawn facility in the second half of 2004 before re-accessing the bond market. In other words, it used the loan market chiefly as a sort of insurance policy, while staying in the bond market for its long term funding.

Cambilargiu: We have been able to generate a degree of price tension between the capital market and the bank market. When we issued our Eu200m bond at the start of 2005 it was a very successful transaction which was priced with a 5.2% coupon, the lowest coupon ever in the European high yield market.

We are convinced that the success of that transaction helped Rémy Cointreau negotiate better terms for future loans, and when we refinanced a syndicated credit in June we reduced our margin from 120bp to 67.5bp. That is clearly not the sort of spread you would normally associate with a high yield borrower.

EuroWeek: Given that the loan market for cross-over credits remains predominantly a bank market, borrowers tapping into the high yield bond market can presumably also access an entirely different and complementary investor base?

De Carne: Absolutely. Finance directors and CFOs have definitely recognised that having a foot in both the high yield bond and the loan markets is a very sound strategy, because sentiment in both markets can change very rapidly.

But I also believe that with the implementation of Basle II and with the additional cost of capital that bank lenders will be required to put against non-investment grade companies, the bond market will become an increasingly attractive alternative.

EuroWeek: We have already established that the loan market for cross-over credits is largely a bank market. But is there any overlap at all in the investor base for cross-overs, either in the loan or the bond markets? For example, are total return accounts starting to compare the relative value across the two asset classes?

De Carne: That is a very interesting point. More and more asset managers, sometimes wrongly referred to as hedge funds, are emerging which are long credit funds with very flexible management mandates. They are able to play throughout the capital structure, from secured and unsecured senior loans all the way through to the deeply subordinated Pik [payment-in-kind] notes.

One of the most significant developments over the last year or so is that those investors are doing much more pure relative value analysis. They are then mixing their investments based on their fundamental view of the credit story, the company and the management team.

So there are definitely more and more sophisticated and knowledgeable investors in the market who are well aware of relative pricing trends in the high yield and loan markets.

EuroWeek: What trends have you seen in terms of documentation and covenants in the high yield market for cross-over borrowers in recent years?

De Carne: Investors have become more comfortable about double-B issuers coming to the market with a much looser set of covenants, and we think that trend will continue.

If you look at names like Fiat, which is expected to return to the market soon, and Alstom, which is unrated but generally regarded as a double-B borrower, they are now able to come to the high yield market at very tight levels but with a very light set of covenants.

That is a reflection of the continued trend we are seeing of investors becoming more comfortable about moving down the credit curve, and the most active part of that move at the moment is their migration from the triple-B to the double-B area of the curve.

So rather like the bank lenders in the cross-over space, I know that when I pitch a bond issue to a double-B borrower I have to be competitive in terms of the covenants I impose.

There will usually be a change of control covenant to protect bondholders against the impact of an LBO, and a few simple financial ratio covenants, and that will usually be it.

Cambilargiu: The capital market generally demands tighter business covenants than the bank market, but in terms of financial covenants it has been the opposite, with the bond market much lighter.

We have found that if you want to secure a waiver in your documentation from the bank market the process is fairly straightforward as long as your request is reasonable.

Achieving the same thing in the bond market can be much more difficult, and I mention this because in June we disposed of our Polish operation, receiving payment partly in cash and partly in shares. As a result, we needed to modify our bond covenant package with a consent solicitation, which I believe was one of the first of its kind in the European market. We did so successfully, but we needed to secure the agreement of the majority of our bondholders, which meant distributing a prospectus, which was costly and time consuming, as it was a six week process.

So from a business perspective it is clear that if you're not among the highest grade companies the capital market can put a number of constraints on you.

EuroWeek: Returning to loans, how liquid is the market for cross-over credits and do lenders in this space look to manage their portfolios actively?

Swift: I don't believe we will see as much liquidity in the cross-over market as there is in the leveraged loan space, which is probably another reason why the funds aren't very active in cross-overs.

But never say never. I don't think anybody predicted that we would see as much liquidity in leveraged loans as we have in the last year, so maybe we should be wary of saying that the cross-over market will remain relatively illiquid.

Neo: But liquidity in the cross-over space has improved considerably. Over the last year and a half liquidity in the loan market has been catching up on the bond market very quickly.

Leech: Our experience is that there tends to be a lot more liquidity in cross-over names in the bank market than there is in the 'A' tranches and revolvers in the leveraged loan market.

We are not relationship-driven, so we will look for transferability and assignability in the cross-over market, and things tend to be quite straightforward in that regard. We have certainly found that we have generally been able to sell positions when we needed to without much of a problem. Although treasurers may not wish their deals to be traded, there has been a perfectly liquid market in names like Yell and RHM.

EuroWeek: The relationship angle is an interesting one. How much of a role does relationship banking play in the market for cross-over credits?

Swift: Relationships can play a very important role. In many cases, lenders will be prepared to make a compromise if they feel they are putting in place a relationship with a company that in time will become investment grade.

In those circumstances a lender will have to be very comfortable that it has the expertise and the necessary product range to offer a borrower; and the lender must also be willing to accept a compromise in terms of pricing, because these deals will not be priced as leveraged loans. Although some non-investment grade cross-over deals may be priced at very substantial premiums to the investment grade market, deals of that kind are few and far between.

One of the main attractions of this market for banks is that it holds out a variety of attractive scenarios. One is that the credit improves, the company refinances at better terms and develops a relationship with the lender that can bring in a variety of ancillary business opportunities. Another is that the corporate looks for further acquisition possibilities and therefore takes on additional leverage — either in the form of a new transaction or through a restatement of an existing arrangement.

Either way the opportunity will be interesting for lenders because it will involve drawn facilities, which is a welcome development for banks, given the extent to which commitment fees have fallen in recent years. It is not as though you are talking about arranging a seven year facility for a company which is single-A today and will always be single-A.

EuroWeek: Will lenders in this market tend to talk to the same individuals at the arranging banks as they would in the investment grade loans market?

Leech: Yes — because the teams taking responsibility for sales and distribution of cross-over loans will generally be the same as those that would arrange and distribute the investment grade material. They are not necessarily the same teams that would be originating and structuring deals on the leveraged loan side.

Baines: Especially in the case of fallen angels, if banks think they can continue to extract ancillary business from these larger companies they will keep the same relationship management people, although they may also find that they need to bring in specialists from elsewhere within the bank who understand the requirements of sub-investment grade companies.

Cambilargiu: When we've issued in the bond market we have obviously spoken to a number of high yield investors, so we are aware of a differentiation there. But when I have spoken to bank lenders there has never been a distinction between the people specialising in high grade and cross-over corporates.

EuroWeek: Presumably in the case of some of these firms — and I'm thinking mainly of the large industrial fallen angels — bank relationships can date back decades?

Swift: True.

EuroWeek: For a full service investment bank like Société Générale, to what extent is there a degree of internal competition between the loan and the high yield bond desks when you talk to companies in the cross-over space about their funding options?

De Carne: I would describe it as very healthy competition. We have an integrated loan and bond platform, so we operate on the basis of a single P&L, which means there is no internal conflict.

Often we will pitch to companies together, and whenever we price either a bond or a loan we will always be very aware of relative pricing trends and of the degree to which the product will appeal to each investor base. That process contributes to price efficiency.

EuroWeek: If the market continues to grow will we see dedicated cross-over teams starting to take shape, on either the sell side or the buy side?

Swift: I don't think banks have yet organised themselves to take account of the growing importance of the cross-over market. What banks have tended to do is to organise themselves in accordance with asset classes.

LBOs are generally handled by the financial sponsor group or the leverage group, even when they go through the process of IPO-ing and refinancing themselves.

Fallen angels, meanwhile, will probably be handled by the same relationship manager who looked after them when they were investment grade borrowers.

EuroWeek: So none of the banks have started to put 'Head of Cross-Over Credits' on their business cards?

Swift: No, but on the other hand certain banks have developed interesting mid-cap strategies with teams identified to handle such clients. Leveraged teams in many banks have for some time had within them groups dedicated to handling mid-market deals.

Leech: I also doubt that we will see banks setting up separate departments looking after the cross-over market in the foreseeable future, because cross-over credits are still not regarded as an asset class in their own right.  But I do think that the market requires very specific skills because we are often talking about very unusual situations.

Baines: At some stage banks will have to start asking if they are properly organised to handle the cross-over market, because at the moment I don't think they are. They tend to be organised in silos which means they really struggle with some of the deals that are neither fish nor fowl but have components of project finance, real estate or leverage. Eventually banks are going to have to adapt to the changes in the market.

EuroWeek: What is the outlook for the cross-over market in 2006?

Leech: In terms of supply this has so far been very much a UK-driven market, so I would expect to see more activity in Europe. I would certainly welcome an increase in supply from markets such as France and Germany, because I believe that the cross-over segment has been part of the UK market for the last 20 years. What this market needs now is more geographical diversification.

Watters: As corporates become more growth-oriented and focus more on expansion opportunities we would expect the number of non-sponsored leveraged companies in the rated cross-over space to grow.

At the same time, we anticipate some tightening of liquidity conditions in the leveraged market during 2006 that should discourage sponsors from doing dividend recap deals in favour of paying down debt and seeking exits by way of sales to strategic trade buyers. This would certainly increase the number of credits migrating into the cross-over space.

EuroWeek: To wrap up, it would seem that in the absence of a major interest rate shock or some other

external bombshell, buoyant demand in both the loan and the bond markets will leave companies in the cross-over space more or less spoilt for choice in terms of their funding options?

De Carne: They do indeed probably have a wider array of competitively priced options than ever before. 

13 Jan 2006