European leveraged finance: From survive to thrive
European leveraged finance markets rebounded in the past 12 months, driven by enthusiastic refinancing activity and a resurgent M&A marketplace, setting the stage for a healthy year ahead
European leveraged finance markets look remarkably healthy as we enter 2022. This may come as a surprise, after 12 months of economic volatility underpinned by everything from a new COVID-19 variant to growing inflationary pressures. What does this mean for the months ahead?
The start of the new year is full of positives in the European leveraged finance market. There has been a clear shift from survival to growth strategies among lenders and borrowers, setting the stage for significant activity in almost all sectors.
The numbers paint a clear picture. European leveraged loan issuance climbed more than 25% in 2021, year-on-year. High yield bond markets in the region were even more enthusiastic, with issuance for the year up 47% on 2020's total.
Ongoing government support in the EU and the UK helped companies that might otherwise have fallen victim to the pandemic stay afloat. Low interest rates and pricing sparked a wave of refinancing. CLO activity—most of which was intended for refinancing and resets—pushed new CLO issuance up by 75% year-on-year.
A bottleneck of demand as well as significant private equity dry powder also brought a flood of new deal money into the market. Companies that were once hesitant to sell encountered enthusiastic buyers aggressively looking for targets. Buyers, meanwhile, found themselves in a better position to judge whether a potential target was likely to struggle or grow in 2022 and beyond. Lenders reaped the benefits, with high deal volume in which to participate. At the same time, unlike many other industries, European direct lending funds avoided any significant downturn in deployment and deal activity due to COVID-19. According to data from Debtwire Par, direct lending issuance in the region reached €36.2 billion in 2021, surpassing 2020's full-year total of €21.4 billion. This provided a liquid and competitive market for finance products.
Possibilities and pitfalls
Set against this positive backdrop, does the future look entirely bright for leveraged finance? Not necessarily—some challenges remain, and each may have an impact on European issuance.
For example, climbing COVID-19 case numbers driven by the Omicron variant may convince some corporates to hold on to their reserves. Any resulting new lockdowns or restrictions could also be the final straw for businesses that have already struggled during the pandemic.
Inflation and attendant interest rate rises are also likely to influence potential borrowing decisions in the coming months. The UK got the ball rolling with its first interest rate rise in three years in December 2021, and the EU may follow suit in 2022—despite claims to the contrary by the European Central Bank.
Any rise in the cost of debt will affect M&A and buyout activity, as well as financing. Some may pause while others—from corporates in good financial shape to PE firms with money to spend—may decide to invest in a post-COVID-19 future. Either way, M&A and buyout deals in the pipeline already suggest that issuance will remain healthy in the first half of the year at least.
And, finally, environmental, social and corporate governance criteria will be on the menu for every European business. New benchmarks due in 2022—from the EU's Sustainable Finance Disclosure Regulation to the European Leveraged Finance Association's updated Sustainability Linked Loan Principles—are already making lenders and borrowers sit up and take notice.
All this activity means the stage is set for companies hoping to thrive rather than simply survive. Lenders chasing higher-yield opportunities will be on the hunt for new investments, and borrowers can be expected to provide lenders with a healthy volume of demand for debt financing in 2022.
From survive to thrive: European leveraged finance looks to the future
European leveraged loan issuance was up by more than a quarter, year-on-year, to €289.7 billion in 2021
High yield issuance reached €148 billion in 2021, up 47% on 2020 (year-on-year)
Refinancing accounted for approximately half of overall leveraged loan and high yield bond issuance for the year
Both M&A and buyout activity saw double-digit year-on-year rises in deal-related issuance
A flurry of activity saw year-on-year leveraged finance issuance in Europe hit new heights in 2021. Can this pace be maintained in the months ahead? Based on pipeline activity and investor appetite for growth, the answer seems to be: Yes.
New European collateralised loan obligation (CLO) issuance in Europe is up 75% year-on-year, reaching €38.5 billion in 2021
CLO issuance intended for refinancing and resets came in at a record €57.5 billion for the year
By July 2021, 34% of the EU's total assets under management was compliant with the region's new Sustainable Finance Disclosure Regulation (SFDR), and this is expected to climb to more than 50% in 20221
Europe's CLO market and environmental, social and corporate governance (ESG) objectives are converging at pace, providing unique opportunities for CLOs to access the vast and rapidly expanding pools of capital earmarked for ESG-linked investment.
The past 12 months have been good for European CLOs in general. New CLO issuance in Europe reached €38.5 billion by the end of 2021, up 75% year-on-year and peaking in November 2021 at €6.3 billion, its highest level on Debtwire Par record. Refinancing and resets drove record-breaking CLO activity during the year, coming in at €19.6 billion and €38 billion, respectively, for the year.
At the same time, ESG factors have become increasingly influential across global debt markets, initially in the investment-grade and sovereign segments before trickling down into the leveraged finance space. Back in 2019, Italian electricity and gas distributor Enel was the first corporate issuer to print a sustainability-linked corporate bond related to the United Nations sustainable development goals (SDGs) and, in 2020, Mexico brought the first sovereign bond referencing the SDGs to market.2
As these high-profile ESG-linked financings grabbed investor attention, CLO managers in Europe started to build ESG 'negative screening' measures into their credit criteria. Loans from issuers in sectors such as nuclear weapons, coal and tobacco were left out of the mix. Document research platform Dealscribe estimates that up to 15% of CLOs excluded credits because of ESG concerns back in 2018. Since then, ESG has moved swiftly up the agenda—in 2021, Dealscribe put the number of CLO deals with a negative ESG screen at close to 100% in the UK and European market.3
The SFDR game changer
Europe's CLO industry, however, is only at the start of its transformational ESG journey. The catalyst for this shift is the EU's Sustainable Finance Disclosure Regulation (SFDR), a policy initiative that sits alongside the bloc's Taxonomy Regulation.
The SFDR was designed to funnel private capital into both the energy transition and the equality transition. In a nascent ESG market, which is still coming to grips with how to benchmark and prevent 'greenwashing', the SFDR is fast becoming a global standard, providing rigorous definitions of what qualifies as environmental and social assets. It has been so successful that many investors in the US are also now adopting the SFDR as their benchmark, even though they are not directly subject to it.
The SFDR is relevant for CLO managers because it allows for the formation of what are known as Article 8 and Article 9 funds. Article 8 funds are more broadly defined as those that promote environmental or social characteristics, while Article 9 funds have a more stringent primary objective of sustainable investment.
The appetite for any funds that meet the ESG criteria required to qualify as Article 8 or Article 9 vehicles has been profound. Within four months of the SFDR coming into effect in March 2021, assets under management (AUM) in Article 8 and Article 9 funds had already climbed to €3 trillion, according to Morningstar figures, with the expectation that more than 50% of total AUM in Europe will be held in Article 8 and Article 9 funds later this year.4
For the European CLO market, this influx of capital into what is effectively a brand-new ESG asset class could a spark an unprecedented inflow of cash into CLOs that structure themselves as Article 8 or Article 9 funds.
At the time of publishing, CLO assets under management in the EU stand at €182.4 billion, according to Creditflux. If even a fraction of the €3 trillion that has already flowed in SFDR-compliant funds finds its way into the CLO market, the segment's size will increase by multiples.
Meeting the criteria laid out in SFDR is already well within the reach of CLO managers, most certainly with respect to Article 8 status.
Reporting and compliance is relatively light touch, with managers having to provide a brief pre-contractual disclosure committing to their ESG criteria and then report quarterly on their progress towards those objectives. This is comfortably within the capabilities of CLO managers, who will already have infrastructure in place to meet securitisation reporting requirements.
Recent guidance from the European Supervisory Authorities, the joint European regulators, confirms that the inclusion of an ESG exclusionary screen is sufficient to qualify as Article 8. The screen is a minimum entry level, but Article 8 is structured to be flexible and allows for varying 'shades of green'. For example, the ESG screen in Article 8 funds is at the 'light green' end of the spectrum, while darker green Article 8 funds (e.g., those with a high minimum sustainable investments bucket like 99.9%) are only one shade lighter than the fully dark green Article 9 funds.
This removes barriers to entry, as managers do not have to commit to a complete overhaul of their investment strategies, but can position themselves on the spectrum so long as the minimum hurdles are cleared. Also significant is the fact that not all CLOs that a manager runs must be Article 8-compliant—the plan is voluntary and applies per product rather than necessarily to the manager at the entity level.
Even before the SDFR came into effect, the market saw Neuberger Berman launch a new European CLO tethered to the UN's SDGs, believed to be the first of its kind. The flexibility of the SFDR regime, its global credibility and the deep pool of funding that it opens up will only accelerate this ESG investment theme.
We can expect to see the first Article 8 CLOs emerging perhaps as soon as the first half of 2022, with the potential for the CLO market to migrate en masse to Article 8 in the next 12 to 15 months.