Light on leverage

Despite a flurry of activity at the beginning of 2016 to keep leveraged loan bankers busy, overall business in the year to June was disappointing and new issue volumes considerably lower than during the equivalent period of 2015. It is not as though the phenomenon can be explained away by a lack of support within the investment community: the problem is one of supply. Bankers expect deal flow will return, but volumes are unlikely to catch up with levels seen in recent years.

According to Thomson Reuters data, volumes of global leveraged loans reaching financial close by the beginning of June this year are 32% lower than the figure registered in the first five months of 2015. In terms of US dollar deals, issuance is down by 25%, while in euros the drop is one of over 50%.

Bankers offer a number of suggestions to explain the collapse in volumes, but clearly it is not the result of a lack of demand for leveraged debt. If anything, the clamour for deals sporting a bit of extra yield is larger and stronger than ever.

“The technical backdrop to the market remains strong,” said Tom Egan, head of EMEA leveraged capital markets at Barclays. “There’s definitely not a buyers’ strike.”

Appetite among the buyside and banking community for returns outside of the investment-grade sector is evident, both in the traditional Single B leveraged loan space and the Double B high-yield bond arena.

Structured funds, for instance, continue to put money into the market and new CLOs are being ramped up. KKR Credit Advisors was one name among many marketing a new euro-denominated CLO deal in June, with several other managers also aiming to print.

“It’s good to see new money coming into the market through CLO issuance after a dismal start to the year,” said Charlotte Conlan, head of EMEA high-yield bond and loan syndicate at BNP Paribas. “It remains a cornerstone of the European market.”

Elsewhere, there are signs that unitranche structures, more usually common in smaller deals and often seen as a sideshow to the direct lending environment, are reaching a wider level of appeal due to challenging M&A conditions and increased competition for paper.

Combining senior and subordinated debt into one instrument provides the lender an attractive yield of around 8%–9%, according to bankers. It is also attractive to sponsors, as it provides certainty against volatile markets.

In May, GSO Capital Partners completed the largest ever unitranche financing in Europe. The €625m loan backed the merger of Italian chemicals company Polynt and Reichhold in the US.

This kind of activity, along with direct lending, is partly responsible for taking deals out of the syndicated market, but its impact is usually felt in the smaller trades (less than €100m) and generally has a peripheral influence on syndicated activity. However, as illustrated by the GSO exercise, the upper limits to direct lending and unitranche structures are rising. Nevertheless, direct lending is not a major determinant to the drop in leveraged loan volumes since the turn of the year.

Slimmed-down supply

By far the biggest influences on leveraged loan supply is activity in the underlying leveraged buyouts market and from corporate refinancing exercises – and there was little on show from either of those sources.

The M&A market has been relatively lacklustre overall, and those coming through in Europe, small in size. The problem currently faced in this market is getting deals done. The slowdown in China, plummeting oil and commodity prices, and volatility in the financial markets at the end of 2015 and early 2016 drained the appetite for M&A.

Yet an uncertain economic backdrop was not the only influence on deals that could have been financed by leveraged loans. The market also had to contend with increased competition for assets.

“It has not been easy to marry up the bid/ask gap,” said Chris Munro, co-head of EMEA leveraged finance at Bank of America Merrill Lynch. “Corporate balance sheets are healthy, so there is no desperate need to sell, and sponsors have not been chasing valuations.”

They may not have been chasing valuations, but they have been up against increasing competition for assets. Chinese corporations are getting busy with their overseas buying spree and there are also signs of a growing number of Chinese private equity firms looking to compete for assets with their more recognisable global rivals.

It is not just the dynamic in the buyouts market that is affecting loans volumes.

“The leveraged loan market has had some bad luck,” said Egan. “We’ve seen potential loan deals go to the bond market, as well as assets going straight to corporate buyers or down the IPO route.”

Hopes were high in April that auctions for Philips Lighting and the disposals from the Ball Corporation and Rexam merger would result in leveraged loan activity. These hopes were quashed, however, when Philips opted for a straight sale via the equity markets and Ardagh Group went to the bond market to generate funds for its acquisition of the beverage can business from Ball and Rexam.

Both of those deals went well, too, with Philips shares rising by 10% on the first day of trading and Ardagh attracting enough interest for its multi-bond, multi-currency package that it could upsize the deal size from US$2.85bn to US$4.5bn.

Corporate refinancing has also been slow this year.

“A number of corporates have already taken advantage of the benign credit markets of the last few years to tidy up the balance sheet,” said Munro. “A lot of opportunistic financing was completed in 2014 and 2015.”

Not only have corporates ridden easy monetary conditions to lengthen duration and revisit covenants but they have also been spoilt for choice in how to do so.

“Local banks are back in the market, offering attractive loans at competitive rates through the likes of revolvers or corporate term facilities,” said Munro.

At this point in the credit cycle, where interest rates are so low and investment-grade margins painfully slim, while defaults are thin on the ground, it makes sense for banks to open up the balance sheet to some meaningful returns by searching a bit lower down the credit spectrum.

A little bit of give

With demand far outstripping supply, the main variable that usually gives is pricing. Deal repricings began filtering through to the market during the first half of the year and there is likely to be more to come. Bankers caution, however, that the opportunity to reprice is not open to everyone and that there is a limit as to how far spreads can be shaved. For CLOs and structured buyers in Europe, for instance, bankers put the cost of capital at 4% and over, so there is only so much leeway on deals to reprice before the economics just do not work.

“Investors want 5%–5.50% yields, so the capacity to redress pricing on many deals is limited. But with constrained deal flow and a need to keep money invested, we will see a number of the larger liquid deals able to reprice” said Conlan

For deals tightening in the secondary market from businesses that are performing well, there is invariably a degree of flexibility.

By the end of May, MKS Instruments, for instance, was already scheduling a lender call to launch a repricing of its US$780m Term Loan B. That deal was arranged in April by Barclays to support the company’s acquisition of technology products supplier Newport Corp. The loan originally priced at 400bp over Libor with a 0.75% floor, which was already 50bp less than the initial guidance.

The other potential outlet for supply is the dividend recap markets, and by June there were signs that more borrowers were considering this kind of action. Ferrara Candy, Avantor Performance Materials Holdings and CHG Healthcare all appeared in the market looking for funds from the loan markets to be distributed to shareholders.

But is that enough to get volumes back up to levels seen in 2015?

“We’re in a good spot,” said Conlan. “Senior secured leveraged loans are still attractive in terms of what you are paid versus the risk of default, CLO production is getting better and the US market is getting tighter. We’re taking risk now for summer and September placement.

“But what we really need in Europe is a run of loan and high-yield deals of €400m-plus in Single B and B+ names, this rather than mid-market club deals will be the life blood of a resurgent European leverage finance market.”

There are still some obstacles to overcome before sufficient confidence has returned to generate the desired flow of loans – not least the UK referendum on membership of the European Union. Although not significantly impacting the loan market, a sector traditionally less volatile than other asset classes, it has been cause for consternation, dampening enthusiasm for risk and leaving participants to adopt a cautious stance.

“While there’s still a fair amount of uncertainty and volatility, there’s also a lot of dry powder on the sidelines and a number of interesting processes ongoing in the European pipeline, so we are cautiously optimistic about the prospects for the markets” said Munro.

Perhaps uncertainty and volatility will start to dissipate once the British electorate has given its decision on remaining part of the union, and that could ignite the powder.