While the central and eastern European (CEE) credit landscape could hardly be more diverse — from the strong investment grade Czech Republic to weak single-B CIS states like Moldova — investors’ growing appetite for its more leveraged companies is an increasingly common theme across the region.
“The overall high yield market is seeing very significant growth, from 100 issuers in 2012 to 210 in 2013, and central and eastern Europe is contributing to this — probably a bit more than its fair share,” says Tanneguy de Carne, global head of high yield capital markets at Société Générale in London.
“There hasn’t been a big rush but there are encouraging signs that CEE corporates are awakening to the existence of a market that caters to levered companies,” says Dominique LeMaire, global head of high yield debt at UniCredit in London.
On SG’s definition of the market and region, issuers of CEE high yield transactions more than doubled last year. Their total rose from eight in 2012 to 20 in 2013, according to the bank.
However, this growth spurt has been followed by a notable slowdown in 2014 — partly in response to the geopolitical shock in Ukraine. By May issuers had completed only two new deals, although these included a €900m jumbo with a striking Polish zloty tranche.
“We’re disappointed by the pace of activity from the region this year and think there is much greater potential,” affirms SG’s de Carne.
In view of this tailing off, some leading banks still have fairly modest expectations of the region. “My anticipation is that there will be increased activity as the market grows and develops. But are we going to see 15 Polish, Hungarian and Czech high yield bonds in the next 18 months? No,” says Douglas Clarisse, managing director of leveraged and acquisition finance, capital financing at HSBC in London.
All the same, the diversity of CEE credits accessing the sector has seen sharp expansion lately. While companies from the technology, media and telecoms sectors have dominated flows historically, as they have in other high yield jurisdictions outside the region, 2013 brought “very, very different types of issuers from different markets”, according to de Carne at SG.
The arrival of Ukrainian agricultural and energy firms illustrates last year’s “healthy and encouraging” broadening of the sector’s issuer base, he argues. 2013’s raft of debut deals by telecom names from Bulgaria, Poland, Romania and Serbia/Slovenia reinforce the point.
Historically, most CEE high yield issuers have come from the region’s economic powerhouses — the Czech Republic and Poland. Smaller jurisdictions such as Croatia, Hungary and Lithuania have also contributed occasional deals too.
CONVERGING INVESTOR BASES
While the size and strength of the Czech and Polish economies leave few high yield professionals doubting that they will remain the engine of CEE HY activity, today’s broader issuer base reflects a growing convergence between two traditionally separate groups of bond buyers.
“There was a real gap between specialised emerging markets investors focused on political risk, who struggled with subordination and weaker investor protections, and European high yield investors, who really struggled with political and FX risk,” notes Henrik Johnsson, head of European high yield and loan capital markets at Deutsche Bank in London. “We have been at the forefront of educating both investor bases in order to find a level of risk acceptable to each.” A typical distribution split on a CEE high yield offering is 60:40 in favour of high yield investors, he suggests.
Moreover, investors’ receptiveness to smaller leveraged companies from the region has expanded notably. Historically, leveraged CEE companies reporting annual cashflow below €75m or even €100m were advised to seek alternative financing sources. But with both investors and issuers more open to smaller deals, “€50m Ebitda is now acceptable to the market,” notes SG’s de Carne.
“There is a lot more tolerance of small scale, well run, reasonably levered businesses and a greater acceptance of risk in smaller deals. If investors do the credit work, they are likely to get a better allocation than in larger deals.”
This development is not unique to CEE credits, however. In 2013 European high yield buyers took down offerings from more than 27 companies reporting Ebitda below €75m, according to SG. This compares to just three the year before.
In the case of the CEE region it may also reflect the limited number of potential issuers. “The demand is there. Supply is the issue. There is a lack of highly levered companies in the region,” says Johnsson at Deutsche.
The extent to which competition from banks to fund the region’s limited pool of leveraged companies is affecting bond activity is a matter of some dispute between high yield professionals. Some report that lenders are retrenching (apart from some Russian banks on expansion drives) — adding to the appeal.
However, others report a quite different picture, at least for some names. “Issuers such as Polkomtel and Polsat now have access to very significant local bank funding,” Johnsson notes.
PE PUSH
Private equity sponsors have been a key source of CEE high yield deals to date. This reflects their greater familiarity with the product than local corporate treasurers. It also testifies to the limited appetite of local banks for financing buy-outs.
“When big deals stretch the capacity of local markets, high yield may make sense,” suggests Clarisse at HSBC.
Polkomtel — at closing in 2011, the largest LBO since the 2008 credit crisis — remains the benchmark. The Polish mobile telecom firm financed its €4.5bn buy-out with over €1.5bn of bonds and payment-in-kind (PIK) notes, each sold in both euros and dollars, as well as bank debt.
Another of the region’s notable sponsor-driven transactions was last November’s €475m senior secured bond from Serbia Broadband. The deal part financed Kohlberg Kravis Roberts’ €1bn takeover of SBB and Telemach, a Slovenian telecom that vendor Mid Europa Partners had merged into the firm.
“[It] is definitely a landmark and provides evidence of how much the high yield markets have become part of the tool kit available to financial sponsors in the CEE region, even in places like Serbia and Slovenia that are not obvious for LBO-type financings,” argues UniCredit’s LeMaire.
The CEE sponsor-driven sector is likely to see further growth, high yield professionals agree. “They like the flexibility that the high yield product provides, given its lack of maintenance covenants or any required amortisation,” comments HSBC’s Clarisse.
The opportunity is greater from the private equity side as they are familiar with the benefits of the high yield product and not afraid of using it in less conventional jurisdictions,” LeMaire adds.
In the face of a strong push by sponsors, however, banks are starting to weaken their traditional demands on loan covenants, high yield professionals report. The emergence of so-called “cov-lite” lending could provide new competition for high yield bonds in the region, though the pool of potential lenders is notably smaller than in western Europe.
The FX risk arising between CEE high yield issuers’ local currency revenues and their bond liabilities in euros (and, occasionally, dollars) concerns some investors. This has led them to require a number of issuers to hedge their currency exposure — though the majority of deals have been issued unhedged as their buyers actively sought exposure to a potential appreciation, according to bankers.
Play’s jumbo debut bond this January was notable for including a Polish zloty tranche. The five year non-call one senior secured FRN reached Z130m.
UKRAINE UNCERTAINTY
Russia’s annexation of Crimea and Ukraine’s subsequent splintering is exerting a heavy toll on CEE high yield activity. Some banks blame this geopolitical shock for this year’s slowdown.
“The impact of the crisis is a big question mark that we’re grappling with every day,” says SG’s de Carne. “The market is attracting new money and continuing to build on what has been achieved already, but that could be dampened by fear among less informed investors worried about spillover.”
“There is a risk that people get spooked by the impact of sanctions, for example,” agrees UniCredit’s LeMaire, though he emphasises that the CEE market has “decoupled” from Ukraine so far and highlights “solid performance of CEE issues in primary and secondary markets”.
Others are sanguine over the likely extent of contagion. “Unless the situation gets significantly worse, meaning more aggressive sanctions on Russia and cuts in energy supplies in response, we don’t see it impacting the high yield market,” says one banker.
LeMaire also “would imagine that if things get resolved decisively in Ukraine, it could trigger a quick and broad re-opening of the markets to Russian issuers in particular, as their funding needs are massive and investors cannot ignore forever such an important part of the emerging market issuer base”.