Requiem for a market

Wounded by previous excess, new issuance in the leveraged finance market ground to a halt in 2008. And with the market sustaining enormous damage, the outlook for the coming year is even less favourable, with little hope for recovery before the end of 2009.

Deleveraging in all markets means that the hedge funds and CLOs that drove activity to the top of the market have been sidelined. They are now more active as forced sellers of debt than as buyers and there is no clarity on when or how new liquidity could come into the market to replace that bid.

“I don’t see any quick solution to this,” a US loan trader said.

In this grim scenario a resurgence of the new issue market is not expected in the first or second quarter of the new year. Volumes in the US are expected to remain flat or below those of 2008. The total volume of leveraged loans in the US for 2008 was US$710.4bn with 201 issues, according to data from Thomson Reuters. In Europe, investors expect the first half of 2009 to be a continuation of the post-October slump.

Although some new issue activity is expected, experts suggest lending activity in 2009 will focus on undoing the excesses of the boom years.

In the US, amendments will address coming maturities and covenant breaches. Debt restructurings and debtor-in-possession financings will provide support for over-leveraged companies that had to seek protection under Chapter 11, and debt exchanges and debt buybacks will only contribute to reducing the companies’ hefty debt loads.

The outlook is no better in Europe, where there is an undoubted need for rescue financing and so far no one has quite figured out how to raise the right funds or to execute deals across its mix of jurisdictions.

Secondary troubles

Depressed secondary prices have caused the new issue market to grind to a halt. As long as investors can buy names in the secondary market in the high 60s, demand for new credits in the high 90s will be non-existent.

That said, the 20% returns that senior secured debt can now offer could well eventually attract buyers and new issuance could start to pick up. Unfortunately, no one knows when and how that could happen.

“The B loans are going to sit here and trade poorly. Hopefully, at some point there will be some pockets of liquidity out there that will recognise the tremendous value that you have in senior secured loans where you can get 20% returns,” a second US senior banker said.

“As that money flows in it will slowly bid the market up and at some point there will be more new issuance. But we’re just a long way from that.”

A European debt investor sees a similar dynamic. “Debt and equity investors are focused on their portfolios, trading is tough, and financing is not available. There has been an assumption that at some point deals will start to be done, but it is hard to see what the catalyst for that might be,” he said.

With the LBO market virtually moribund there will be a limited scope to complete new deals in 2009. And those that are possible will be of limited size and higher up the credit scale than traditional LBOs.

In the US one banker said that meant “corporate Double Bs, better companies with diverse cashflow streams, no-brainer credits and investment-grade deals. People just don’t want to be challenged”, he added.

In Europe, the trend will be similar, with deals limited to quasi-infrastructure transactions such as sponsor-backed airports and waste management buyouts, and leveraged corporate acquisition deals.

The bond market is expected to be more open for business in 2009, even if at high prices. Last week, the US market watched closely a bond deal for energy concern El Paso launched and priced. The US$500m senior unsecured five-year bullet was issued at 12% with a discount of 89 to generate a 15.25% yield.

New and old buyers

With most hedge funds and CLOs out of the picture, the composition of the market will also change. Banks will remain as consistent players, despite dealing with their own issues. To ensure bank support, deals will feature more traditional structures.

As in the US, European bankers expect banks to support leveraged corporate financings, which will offer increased margins plus the ancillary business LBOs tend not to offer.

The rest of the gap could be somewhat filled by newer participants in the loan market – possibly US and foreign pension funds, which are expected to become more active. Sovereign wealth funds and private equity investors are also tipped to step in as returns increase.

“Rather than investing in hung loans or distressed loans they will invest more in performing loans that are trading poorly because of market technicals,” the second US banker said.

Some activity could come from traditional hedge funds that already play in the loan market and other unleveraged hedge funds, or those that do not face redemptions such as Fortress and Centerbridge.

Refinancing challenges

Refinancings are expected to be a significant challenge next year. The market has shrunk and there is a lot more paper outstanding than there are investors. When the 2009 and 2010 maturities come due, the market to refinance those obligations will be smaller. The quality of the companies and their relationships will then be more important than ever.

“I think it is going to be a story of have and have nots. Some companies have good relationships and have good support from banks and they’ll be able to get some refinancings done, and there are others that as soon as there is a chance everybody is going to head for the exit,” the second US banker said.

Companies on both sides of the Atlantic are also expected to face covenant breach challenges, leading to a spike in defaults. In the US, market participants are expecting a 8% to 11% rise but it remains too early to tell just how far defaults will climb. This will also open further opportunities for traditional distressed investors.