Loans on top as HY struggles in difficult levfin market
While the last few years have been all about the European high yield bond market rapidly developing into a dependable financing source for private equity sponsors, 2015 saw the loan market fight back. But as Max Bower and Victor Jimenez point out, it has done so at a time when LBO sponsors face increasing competition from IPOs and trade buyers.
Private equity in Europe is going through the opposite of a purple patch. A grey patch, perhaps. Market participants struggle to pinpoint the cause, as although PE firms have tonnes of cash to invest, they are just not swinging the bat to the deadly effect they have in the past.
While PE firms have had some notable victories over the IPO market in the past year — KKR with UK ticket booking service Thetrainline.com, Brait with New Look and Virgin Active and Cinven with Labco — they have also lost many a battle. Perhaps the highest profile was Worldpay, the payments processing firm, where Advent and Bain sidelined private equity bids and conducted the biggest IPO on the London Stock Exchange for two years, raising £2.5bn in October.
It is not as if the public equity markets have been without their troubles, either. But the result, for the moment, is subdued volumes in leveraged finance markets, both loans and bonds.
Running out of steam
By December 18, Dealogic had counted $244bn of leveraged loan issuance and $86bn of high yield bonds, down from $287bn and $132bn for that point in 2014. The pattern is that levloan borrowing has been flattish for the past three years, at a higher level than between 2008 and 2012, but not equalling the pre-crisis boom years of 2007 and 2008. High yield has far surpassed its pre-crisis peak, but its impressive growth ran out of steam in 2015.
The issue is not any fundamental withdrawal by investors from leveraged credit. Default rates remain extremely low, projected to be 0%-1% in high yield and 0.5%-1.5% in leveraged loans, according to Credit Suisse research. And terms are loose, with covenant-lite loans common.
Instead, participants blame market volatility for making investors — and issuers — nervy.
“Greece did weigh over the market through the summer,” says Paul Gibbon, managing director of leveraged capital markets at UBS. “It was the uncertainty causing problems, not the issues themselves. Then after Greece, you had the problems in China, and then the focus on the US Federal Reserve’s September rate decision, which all slowed the market.”
Zak Summerscale, head of European high yield investment at Babson Capital Management, says: “I think there’s more paper coming down the pipe in the bond market from opportunistic refinancing stuff. That depends purely on market conditions and that’s why borrowers are holding back at the moment.”
These macro-economic shocks split 2015 into two distinct halves: before and after the summer break. But although the leverage finance market remains in the darker, post-summer mood, there is a sense among investors that, while there may be further shocks in 2016, these won’t be as surprising or as debilitating.
“Markets feel very choppy, but I tend to be optimistic for 2016,” says Fabrice Jaudi, chief investment officer of fixed income at S&P Investment Advisory Services in London. “Volatility could remain as current uncertainties remain, but I believe high yield corporate bond prices already account for most of the bad news given the current valuation levels.”
Private equity will not be able to keep its powder dry forever, Summerscale points out: “Private equity now has record assets for investment in Europe, bigger than they were in 2006 and 2007. Eventually, that’s going to get deployed, so I’m pretty bullish on a two year view.”
Some senior bankers are less upbeat, however. “I don’t think the pipeline’s fattening up for 2016, there is an underlying lack of assets to go [to sale],” says Gibbon. “There’s always going to be a pass-around among sponsors with LBOs, but at some point that’s got to stop.”
Pendulum swings back to loans
The dynamic between the high yield bond and leveraged loan market also appears to be changing. Tanneguy de Carné, global head of high yield markets at Société Générale, says: “The senior secured bond market kicked off in 2008. We had a scarcity of demand for leveraged loans so the high yield market stepped up and provided that demand. That gave rise to a market which thrived until the leveraged loan market has started to rebuild trust among investors.
“It became clear last year that there was sufficient loan demand to compete with the bond market.”
Gibbon goes further, saying: “The loan market, by adapting and going cov-lite, has made itself much more appealing and open now with respect to the high yield market.”
Tepid bond markets
CreditSights published a research note in November describing the European high yield bond market as “tepid”, with the wave of big issuance some expected in the fourth quarter having proved elusive as markets became more picky.
Mathieu Chabran, managing director and chief
investment officer at Tikehau Capital Management in Paris, says: “There were a number of small cycles in the European space. Veritas post-summer is a good illustration of the market’s now prevalent selectiveness.”
Veritas Technologies pulled $2.5bn of bonds for its $8bn LBO by the Carlyle Group in November, as well as a $3.3bn loan package. The deal was set to be the largest software LBO in recent years, according to CreditSights, however, investor concerns led the deal to be pulled with many complaining about the capital structure and leverage ratios.
Jaudi at S&P Investment Advisory Services, however, sees a more positive outlook for high yield going into 2016.
“The European high yield market has expanded quite fast with an increasing number of sub-investment grade corporations having access to the market for financing,” he says. “The strength of the upturn in the eurozone, supported by the current accommodating monetary policy, could improve further, which could help the bond market to sustain its expansion beyond the typical French and German companies to US domestic issuers.”
While the loan market is now viewed as stronger, it is still not as strong as some had thought it may be. Tom Egan, head of EMEA leveraged capital markets at Barclays, says: “Although we had correctly anticipated the drop-off in high yield new issuance, we had expected the institutional term loan market to see increased volume over 2015, as a result of a pick-up in acquisition financing and a continued trend of issuers favouring loans over high yield.
“These trends didn’t pan out as expected, so it was quite a disappointing year for loans as a result.”
Jeff Mueller, portfolio manager and global analyst at Eaton Vance, however, highlights concerns over the underlying dynamics in high yield.
“There is plenty of cash around and particularly investors with global multi-asset credit mandates are largely agnostic to either type of leveraged finance product,” he says. “They pick up interesting opportunities in different currencies and geographies. High yield is suffering from a certain mismatch between a supply of deals that aren’t straightforward from difficult sectors, and demand that is searching for more simple stories.
Chabran agrees with this, and adds that he expects the demand for CLOs to increase in the new year, and for loans to outperform high yield.
However, he points to activity in the loan market that he doesn’t regard as healthy: “I am hoping that people stop doing dividend recapitalisations, it’s a risk shifting strategy which we don’t like.”
Pushing the market too far
In light of the shocks 2015 brought, it would be rash to say the European leveraged finance market is sick. It may, however, have suffered from deals that pushed leverage ratios too far and pricing too tight, especially in the fourth quarter.
Indeed, it is plausible that scepticism on such deals proves the market is, conversely, functioning well. Gibbon says: “The divergence you’re getting in pricing is showing a maturing market that can differentiate between credits. There shouldn’t be wild differentiation, but 50bp or so is healthy.”