
White hot levfin market faces intense 2019
The leveraged finance market has been the best business for capital markets banks this year — but rising debt levels, weakened investor protections and the rapidly growing volumes have brought regulatory attention. Some banks are pulling back from the most aggressive deals, but others are taking their place, and a burgeoning non-bank lending sector is keeping the market white hot regardless.
In 2018 regulators and politicians, from Janet Yellen to the
Bank of England, turned their attention to a leveraged loan market that many
think is overheating. Huge leveraged buy-outs with few investor protections
have put some commentators in mind of 2006 and 2007, and some of the market’s
biggest names started to pick their spots.
This matters to bank bottom lines. Analysis from UBS and
Coalition IndexPlus says Americas DCM is the largest revenue pool in investment
banking — ahead of any individual business line in fixed income sales and
trading or equities trading.
This is largely down to leveraged finance, and any pull-back
in the market hurts revenues. UK banks, by no means the most important players,
had an average monthly exposure to leveraged loans originated but not yet sold
of around £16bn, or 7.2% of aggregate CET1, according to the Bank of England.
Even if banks manage not to get stuck with “hung bridges” or
other risk positions, an absolute drop in deal volume can be crucial for the
health of banks’ underwriting business, while investment banks also lend money
to loan funds, provide warehouses for CLO issues, and earn a stream of
ancillary business from M&A fees to derivatives off the back of leveraged
lending.
Vintage year
With the market going gangbusters, 2018 was a vintage year.
Dealogic/UBS analysis pegged global leveraged lending net revenues earned by
the banks through fees at $13.3bn with a month left to go — down a touch from
2017’s $14.3bn , but well up on 2014, 2015 and 2016.
The market also, until recently, found regulatory favour.
The Federal Reserve and Office of the Comptroller of the Currency in the US
have had longstanding “leveraged lending guidance”, essentially stopping
regulated banks underwriting the most aggressive, highly leveraged deals —
leaving them to broker-dealers and other non-banks.
But this year the banks were set free. The US general audit
office confirmed in late 2017 that the “guidance” should be considered a rule,
and therefore required congressional approval, while in February, OCC head
Joseph Otting told IMN’s SFIG Vegas conference that the banks were free to do
what they want, as long as they had the capital. Under the Obama
administration, the agencies enforced a firm line of no deals over six times
levered — but regulated banks are now freer to step over this limit.
The European Central Bank published its own guidance in
2017, which was supposed to apply from December. But supervisors have moved
softly, and the guidance has had little apparent market impact — deals are
still getting done above the six times level which should “raise concerns”.
“There’s an awareness of the ECB guidelines, but it’s hard
to be sure it’s had a meaningful impact, whether it’s changing behaviour,” says
Paul Mullen, a leveraged finance partner at Hogan Lovell in London. “It’s
difficult to determine whether it is regulation or other factors that are
driving some banks to limit what they’ll offer. The current guidelines don’t
really have any teeth, and it’s not clear they’re being adhered to.”
IMF sounds alarm
By the third quarter, though, tone from the authorities had
changed. The IMF’s annual financial stability report warned “The share of
highly levered and speculative-grade firms in new debt issuance has grown, fuelled
by strong investor demand, looser underwriting standards, and compressed
spreads. Notably, highly leveraged deals account for a growing share of new
leveraged loan issuance and have surpassed pre-crisis highs. Bank balance
sheets have strengthened, but non-bank financial entities have increased their
leverage.”
This was followed by interviews from regulators present and
past all raising worries about the market, and by the Bank of England
presenting a paper comparing the leveraged loan market to US subprime before
the crisis. This contained nuggets of comfort, with the Bank pointing out that
the market was less reliant on short-term funding than subprime, with less
contingent liquidity from the banking system — but with leveraged lending
growing 15% a year, according to the paper, it was worth watching.
Some banks have already taken note, at least anecdotally.
Morgan Stanley chief financial officer Joanthan Pruzan told investors in the
summer: “The market seems a little bit more selective. And good deals are still
getting done well, but we have seen some other deals struggle a little bit, not
necessarily in our portfolio.”
Steven Siesser, chair of the private equity group at
Lowenstein Sandler, says: “I don’t think you can get the same deal done on the
same terms as three months ago, there is a little more tightness on pricing,
leverage and covenants. But deals are absolutely still getting done. Perhaps
there’s a slight bit of the froth coming off the top but lenders, whether the
big money-centre banks or the non-banks, are super-active.
“There are some banks out there trying to be a little more
cautious, but there’s no shortage of money for sponsors. If someone is bringing
in the leverage they’re willing to do by half a turn, the next guy is still
doing a turn.”
Deutsche goes for it
In Europe, according to GlobalCapital leveraged finance
bookrunner league tables, JP Morgan, Goldman, Barclays and Credit Suisse have
all lost ground, slipping one or two places since last year. Meanwhile,
Deutsche Bank, Crédit Agricole, UniCredit and Société Générale have all gained
ground.
Arranger tables also show stark moves, with Deutsche
climbing from sixth in Europe in 2016 to first for 2018 so far. Crédit Agricole
and UniCredit have also moved up the table, while JP Morgan has lost some
share.
Deutsche said in its third quarter numbers that its levfin
market share had climbed from 3.9% to 5% over the past year — partly because
2017 was a particularly tough year for the bank, but also because it’s pressing
forward hard, even as it cuts back to become a Europe and Germany focused
house.
Dealogic/UBS analysis shows Deutsche making $686m from
global leveraged finance fees in 2018, a higher figure than any year since
2014, despite the turmoil in the bank’s C-suite, swinging cuts to fixed income,
equities and investment banking, and a full year without bonuses.
“Even if a bank takes a conservative approach overall, that
bank may still have a deal they particularly like and be happy to be more
aggressive on,” says Mullen. “Perhaps it’s a company or a sponsor they know
well or a situation where they’re offering strategic support.
“The fact is, there’s such competition in the market that
people are prepared to do things on pretty aggressive terms. It’s about knowing
when to draw a line and walk away.”
Non-banks raise their flags

Behind the regulated banks jockeying for position is the
huge growth in non-bank involvement in the leveraged finance market. While some
regulated banks may be picking their spots and others gaining share, this is
dwarfed by the increasing slice of the market taken by non-banks.
Research from Prequin shows more dry powder for private debt
in Europe than ever, nearly €60bn in the first half of this year, while last
year, 61% of European private debt deals went to funds rather than banks, up
from just 19% in 2010.
These funds often target the smaller deals, but behind the
syndicated leveraged loan market is a CLO market that’s still going from
strength to strength, with $120bn issued year to date, up from $118bn last
year. UBS said loan mutual funds, too, grew from around $20bn in 2007 to $170bn
last year.
The flow of CLOs, in turn, is anchored by a robust bid from
Japanese banks, in particular, for the senior notes which form the majority of
the deal size. Unless Japanese government yields spike, these banks are likely
to continue forming the foundation of the market — and CLOs are going to
continue hoovering up loans as they ramp up.
Debt funds and non-bank lenders also play a crucial role in
the more aggressive parts of the market.
“In the more stretched piece, non-bank lenders are
continuing to play a very active role. There’s just so much money available
chasing deals in the sector,” says Siesser.
Mullen says: “Clearly the banks are concerned about their
loss of business to the funds, and some are thinking creatively about ways to
protect their market share — for example, formal tie-ups with funds, which
allow them to present sponsors a joint solution, or lining up funds as a sell
down route before originating.”
Fed fears
Next year, despite the regulatory sabre-rattling, there are
few things likely to trip up the market. Recent equity volatility has slowed
deals and encouraged some sponsors to postpone their most aggressive issues.
Renewed trade wars, slower growth expectations or market disruption could
derail the leveraged finance train — just as they could derail other markets.
But the biggest issue for this mainly floating rate market
is the expected Fed rate hikes. UBS estimates that there is $3tr of US
speculative grade floating rate debt, not just public, syndicated deals but
including mid-market and bilateral issues. It expects that CCC-rated borrowers
will start to be downgraded if Libor rises between 75bp and 100bp, as this
might mean some borrowers struggle to service debts. If the Fed holds off until
May the market could keep on trucking all year.
Banks are keen to emphasise that this cycle is different —
and, perhaps, for them, they’re right. Even Deutsche, shooting back up the
league tables, claims: “We certainly are not increasing our risk appetite… we
are doing the underwritings in line with our existing risk appetite… with the
expertise we have both on the front office, but, in particular, also on the
credit side, we feel absolutely confident,” according to chief executive
Christian Sewing on wthe bank’s third quarter call.
But caution from the regulated sector won’t be enough to
take the heat out of the market, as funds rush in where investment banks fear
to tread.