According to Thomson Reuters, leveraged lending in Europe for the first half of the year totalled just US$49bn, an 81.9% decline from the US$272.1bn raised during the same period of 2007. The figures are stark but hardly a surprise.
However, quarter-on-quarter, a number of incremental changes made for a somewhat more comfortable underwriting and execution environment. First, the return of some institutional investors to the primary market added a decent slug of liquidity – albeit at a price – while the sell-down of overhung legacy deals helped to free up underwriting capacity. These factors helped the average loan size to increase at the same time as a fall in the size of lead arranger groups.
In the US, volume in the first half was US$200.7bn compared with US$606.5bn in the 2007 period. The number of issues dropped to 661 against 1,174 in the first half of 2007.
In both Europe and the US, the sell-off of overhung debt unsold from last year kept many people employed, if not necessarily gainfully. The sell-down of deals such as Alliance Boots senior debt, which cleared at 91 in huge size, certainly helped to add underwriting capacity, and for the most part the process has cut across both investment and commercial banks.
Lenders to the fore
One noticeable feature of the first half has been the relative outperformance of commercial banks.
“Given reduced liquidity, activity from the investment banks is fairly limited, creating an opportunity for commercial banks with balance sheets to increase market share,” said David Walsh, head of acquisition finance at Bank of Ireland. “One advantage is that the more holds that banks are comfortable taking the less flex they need to underwrite a deal,” he added.
Walsh sees building on existing lending relationships as another advantage to winning mandates: “Staples and ‘soft staples’ are a key way into deals in the current market, we have seen that with IDH and with Euromedic, for instance, where banks credit-approved pre-deal are in a very strong position.”
Despite a small number of larger deals, the concentration of activity in the upper mid-market and the relative out-performance of mid-market sponsors versus mega buyout funds also played away from the strengths of the investment banks.
That said, primary deal sizes have been rising and at the same time there has been a gradual reduction in the number of lead banks involved in club and club-like deals. This means it is now possible to do a deal of more than €1bn with three or four banks where a loan of just €300m needed five or six banks at the start of the year.
Looking for liquidity
With liquidity in the high-yield market untapped throughout the first half, arrangers have structured deals around the bank bid for senior debt, with some traditional institutional investors creeping back into the market in the second quarter.
Charlotte Conlan head of leveraged finance origination at BNP Paribas, sees the latter as a key step. “A big difference from first to second quarter has been the return of some fund liquidity to the primary market. For a number of reasons, including some new money being raised, pre-payments, and also because the secondary market has been so picked over already leaving investors keen to develop portfolios with new assets,” she says.
Most successful deals now feature a fairly hefty mezzanine tranche, and this has become key to increasing debt size without affecting senior leverage. Tapping mezzanine liquidity has allowed arrangers to cap senior leverage at 4 to 4-1/2 times Ebitda with another 1x to 1-1/2x mezzanine on top.
Chris Baines, managing director in European leveraged capital markets at SG, says the return of an institutional bid is among the factors driving better prices for investors.
“Pricing has crept up over the past quarter and deals that are in sterling and/or rely on a fund bid now need a four handle on the C tranche, for example,” he said. “However, smaller transactions that can be placed using regional bank liquidity are less price sensitive and typically come inside these levels,” he added.
The relative lack of price sensitivity from regional banks in particular though has tempered the extent of price rises in senior debt.
Baines however does see some sensitivity. “As the economy slows down, some investors are reluctant to be exposed to the risk of borrowers taking on additional future debt. Undrawn capex or acquisition lines that fall outside the normal course of business are therefore being reined in and draw down conditions more heavily policed,” he said.
In the US too the approach of summer saw activity pick up slightly in the second quarter, but hopes are low for the second half of the year. “I don’t think the sponsor activity is going to pick up. Hopefully, the economic deterioration will slow and will hit a bottom and we won’t have a tremendous drop in default rates,” said one banker.
“If that happens, the loan market still has a healthy foundation and there’s actually money out there, liquidity to do the deals.” he added.
The decline in deal flow has conversely seen an increase in fee rates.”At the peak of the market underwriting fees were getting compressed down to 1.25% and 1.5%, compared with more than 2% now,” said one senior US based source.
While the second quarter looks positive in hindsight, there is widespread scepticism that can be relied on going forward.
Charlotte Conlan outlined the danger: “Mezzanine appetite may have reduced a little recently but the critical question for the second half is how long banks will maintain their willingness to invest.
“Bank investors have done well in the first half of the year – with strong credits, solid structures and super fees, but there is the potential for bank liquidity to diminish towards the end of the year if they meet their budgets or become more risk averse in an increasingly difficult economic environment.”
And over everything hangs the gloomy global economic outlook, unlike last year nobody is predicting that things will be better in September.