By Max Bower
LONDON, April 17 (LPC) - Market conditions appear positive in Europe’s leveraged loan market, with a pipeline of more than €26bn and strong investor appetite for new buyout loans, but ratings agency S&P is warning against aggressive deals.
The market is seeing a steady stream of large new buyouts as private equity firms seek to deploy around US$1.5tr of ‘dry powder’, in contrast to 2017’s flow of repricing and refinancing transactions as pricing tumbled amid the hunt for yield.
This surge in new deals is, however, set against a more turbulent backdrop with rising geopolitical tensions between the US and Russia, which is increasing market risk for lenders and investors.
The broader investment outlook also looks markedly different to 2017. Equity market volatility returned viciously in February and rising interest rates and inflation continue to preoccupy investors who are already spooked by late cycle dynamics.
“History shows us that the worst debt transactions are done at the best of times,” S&P said in a research note.
Bullish market conditions last year pushed these concerns out of investors’ minds, but the growing pipeline is offering the chance to be more selective as their only defense against eroding debtholder protection and aggressive loan documentation.
“I think there’s real value in simply saying ‘let’s be careful guys - there are a lot of structural issues in Europe,” a loan market professional said.
One senior investor said this week that lending terms were by far the worst he had seen in over 30 years in the industry.
“The issue is the arranging banks are getting pushed around by the sponsors so the documentation is bad on every deal, not just for the stronger credits,” a second investor said.
One of the main points of contention is sponsors’ near unchecked ability to take dividend recapitalisations from portfolio companies, often shortly after acquisitions close.
“The point at which we can take dividends is getting earlier,” a private equity partner said.
Investors are also questioning whether private equity firms’ equity contributions will remain higher than before the financial crisis.
“The documentation is so weak that the sponsor can easily draw down their equity from current levels of 60-40% to 70-30% and lower,” a third investor said.
S&P analyst Paul Draffin said that the risk/return profile of many leveraged loans issued so far in 2018 is at the weakest level since late 2008, immediately before the financial crisis.
A key driver in this has been the predominance of senior debt, said David Gillmor, head of European leveraged analytics at S&P.
Borrowers are choosing to issue more flexible leveraged loans than junior debt in the form of high yield bonds and second lien loans.
“From 2005 to 2007, there was a large subordinated debt cushion, which took a lot of the pain. There’s negligible debt buffer at all now for senior lenders,” Gillmor said.
Draffin and Gillmor also note the deterioration in security for lenders, which for most deals so far this year has only included share pledges instead of fixed charges over assets. This could reduce recovery rates.
“The old market norm for security generally included fixed and floating charges over real assets, whereas now it is typically just share pledges. How strong this form of security is, and what it means for recovery rates, remains to be seen.” Gillmor said.
The second investor said that share pledges have often been used as security historically.
“The security is rarely at the individual asset level of a business anyway. As the companies concerned are a going concern share pledges are often what the security is normally,” he said.
Nonetheless as the credit cycle enters what many view as its final chapter of growth, Draffin issued a simple reminder to the market.
“As we approach the latter stages of the current credit cycle, investor discipline has never been more important. For those lenders that fail to demand an adequate return for risk, and continue to pursue yield in the hope that benign credit conditions will continue, poor returns or losses are inevitable.” (Editing by Tessa Walsh)