Our thinking

European leveraged finance: COVID-19 and the flight to quality

What's inside

The European leveraged finance market remains resilient after a year of unprecedented hardship, as lenders dissect credits to determine the best possible deals, from pricing to documentary terms

Foreword

As we enter 2021, COVID-19 continues to weigh on every decision, from our health to our work and our long-term plans and yet, despite these concerns, European leveraged finance markets have weathered the storm and remain positive about the year ahead

In March 2020, as lockdown restrictions took hold, the European leveraged finance markets ground more or less to a halt. Many feared the worst, as leveraged loan issuance dropped significantly that month and high yield bonds saw virtually no activity at all. Borrowers and lenders alike held their breath, shoring up their finances and waiting to see what might come next. And then, just as quickly, investor sentiment began to improve. By the end of Q2 2020, leveraged loan activity had returned almost to pre-pandemic levels.

And while it slowed somewhat in the latter half of the year, as new waves of COVID-19 swept across the UK and Europe, the final tally was up 11% on the year before—a remarkable achievement, confirming the market’s long-term resilience.

The story in high yield bond markets was equally impressive, ending the year up 10% on 2019 figures, with every indication that it will retain a larger share of the market in the months ahead.

What does all of this mean for 2021?

First and foremost, the influence of COVID-19 will continue to be felt, even as vaccines are rolled out across Europe. Sectors hammered by the first wave—including entertainment and leisure, hospitality, retail, oil & gas and aviation—will struggle to secure financing, having already done what they can to survive. Within those sectors, those that require financing and are able to secure deals are likely to have to pay for the privilege, with leveraged debt either becoming more costly for those whose credit has taken a hit or only being made available on tighter terms.

Second, and in contrast, lenders will turn their attention to high-quality credits or sectors that have found new avenues for growth during COVID-19, such as technology and healthcare.

Third, loan supply will continue to open up—but primarily for those that meet the right criteria. For those well-positioned companies, this flight to quality will continue to offer favourable terms and pricing, and the light-touch covenant packages that were the norm pre-pandemic should remain in place.

At the same time, an anticipated recovery in mergers and acquisitions and leveraged buyout activity will provide an additional lift in the early months of 2021.

And finally, the issues that were front of mind pre-pandemic will continue to influence borrowing and lending decisions, especially environmental, social and governance (ESG) factors—investors will take a positive view of any credits that incorporate ESG criteria in a meaningful way. This will no doubt drive this trend in the months ahead as recovery takes hold and global debt markets return to growth.

Living dangerously: How has European leveraged finance fared in the pandemic?

  • European leveraged loan issuance is up 11% on the previous year to €227.1 billion
  • High yield bond issuance is up 10% on 2019 figures to €100.5 billion
  • Average yields to maturity on high yield bonds widened from 3.8% to 4.7% in 2020
  • Average margins on institutional leveraged loans increased from 338 bps in Q1 2020 to 401 bps in Q4
stock market

Five trends driving post- COVID-19 documentation

  • Terms will move back in favour of borrowers/issuers (for now)
  • Lenders will hold the line in key areas
  • Forecasting and structuring will be a post-COVID-19 challenge
  • Pricing will continue to bifurcate by sector and rating
  • Competition will encourage private debt and syndicated markets to converge
Trends

Buyout rebound reflects optimistic outlook

  • Private equity deal value in Europe totalled €26.5 billion in Q2 2020, the lowest quarterly figure since Q3 2013
  • High yield bond issuance for leveraged buyouts (LBOs) in Europe is up 39% year-on-year to €7.8 billion
  • European leveraged loan LBO issuance declined by 6% to €36.8 billion year-on-year
Financial stock display

Market reset could trigger restructurings in 2021

  • In March 2020, credit insurer Euler Hermes forecast a 43% increase in insolvencies in the UK in 2021, as well as a 26% uptick in France and 12% in Germany
  • By December 2020, ratings agency S&P was forecasting European defaults rising to as much as 8% by the end of 2021
Financial stock display

European CLOs: A mere flesh wound?

  • New issuance of European collateralised loan obligations (CLOs) peaked at just under €4 billion in October 2020 from 12 deals—the highest monthly level since October 2019
  • European CLO new issuance declined 26% year-on-year, with refinancing volumes falling from €6 billion in 2019 to zero in 2020
  • By the end of March 2020, credit ratings on an estimated 10% of loans held by CLO managers were downgraded or put on notice of downgrade—however, the rate of loan downgrades eased and stabilised in the second half of 2020
Financial stock display

Sector split: The very different impact of COVID-19

  • Weighted average bids for healthcare and telecoms credits both priced at approximately 99% of par by the end of 2020
  • Entertainment and leisure and retail loans, meanwhile, priced in the 90% to 93% of par range
  • Between March and September 2020, only the transport and automotive sectors suffered more ratings downgrades and negative outlook changes than the oil & gas industry
Financial stock display

Leveraged finance: The United States versus Europe

  • In the US, leveraged loan issuance for 2020 totalled US$861.7 billion, a 4% year-on-year decline
  • The high yield bond market in the US saw a 69% year-on-year increase to US$428.3 billion
  • The European leveraged loan market increased by 11% to €227.1 billion year-on-year
  • The region's high yield bond market was up 10% to €100.5 billion
Commercial

European leveraged debt in focus

Selected European leveraged loan and high yield bond markets by volume and value

What is shaping sponsor debt decisions for 2021?

  • Leveraged loan issuance for European LBOs dropped 6% year-on-year
  • High yield LBO issuance, however, was up 39% year-on-year to €7.8 billion
  • European direct lending volumes fell from 189 deals in 2019 to 138 deals in 2020
  • Ares Management underwrote the largest unitranche on record with the provision of a £1.875 billion financing package for Ardonagh
Trends

Conclusion

After years of warnings about maturity walls, impending cliff edges, downturns
and interest rate hikes that failed to emerge, COVID-19 was the event that brought
everything to a temporary standstill—but there's every chance that the markets will
explode with activity in the months ahead

Trends
stock market

Five trends driving post- COVID-19 documentation

Insight
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HEADLINES

  • Terms will move back in favour of borrowers/issuers (for now)
  • Lenders will hold the line in key areas
  • Forecasting and structuring will be a post-COVID-19 challenge
  • Pricing will continue to bifurcate by sector and rating
  • Competition will encourage private debt and syndicated markets to converge

Although European leveraged loan issuance almost halved in March 2020 month-on-month and high yield bond markets largely shut down that same month, leveraged finance markets regained their stability relatively quickly following the initial shock of COVID-19 lockdowns.

Entering 2021, the underlying drivers—low interest rates and liquidity—remain firmly in place, with lenders eager for yield and any shifts in documentation and terms expected only on the fringes.

Any meaningful documentary changes introduced in 2020 were prompted largely by short-term covenant waivers or followed failed sell-downs. They typically involved the inclusion of liquidity covenants, carve-outs of pandemics from Events of Default or so-called 'EBITDA before Coronavirus' (EBITDAC) add-backs.

What does this mean for businesses, borrowers and lenders for the year ahead? Five key trends will likely shape the market during the next 12 months.

 

1. Terms will move back in favour of borrowers/issuers (for now)

Lenders have been able to secure some quid pro quo tightening of documents through 2020, due to the many covenant waivers that came around in the first half of the year.

In return for waivers, investors have negotiated items such as liquidity covenants and increased reporting. The UK's digital rail-and-coach ticketing platform, Trainline, along with cinema chain Cineworld and transport group Stagecoach are just a few of many examples. Equally, the muted investor reception to deals that closed prior to the onset of lockdowns meant that pricing widened and covenants were strengthened as these deals struggled to sell.

The waiver changes, however, will soon expire and, as markets normalise, borrowers will likely resist the full extent of these terms on new deals.

Indeed, the terms of financings launched during COVID-19 were little changed from those seen before the market's enforced closure in March, and sustained investor demand for yield was further illustrated when both online classifieds group Adevinta and food ingredients producer Solina reverse-flexed recent loan issues late in 2020.

 

2. Lenders will hold the line in key areas

Although lenders may make some concessions, they will hold the line in certain areas. Weaknesses in documents that came to light during the pandemic will have to be addressed as borrowers, issuers and lenders take a pragmatic approach to deals with the biggest loopholes.

Debt capacity will be in the spotlight, with restrictions on dilutive and structurally senior capacity—which will include limiting the potential for incurring debt at unrestricted subsidiaries and blocking the transfer of valuable assets, most notably IP, to those entities.

UK sports car maker McLaren, for example, recently saw bondholders mount a successful challenge to stop the company from raising additional capital via an unrestricted subsidiary structure.

Super-senior debt capacity may also now be specifically addressed. While there have been high-profile and contentious fundraisings in the US, European credits have successfully raised super-senior liquidity via existing capacity, consensual amendments or through court-sanctioned schemes of arrangement. Lenders will look to switch off the taps for this capacity or prevent any future misuse of covenant loopholes.

Borrowers and issuers may be encouraged to take a sensible approach, rather than pushing for the most aggressive terms in all areas, accepting more justifiable levels in return for useful flexibility elsewhere.

 

3. Forecasting and structuring will be a post-COVID-19 challenge

If the market resets in 2021, it will be interesting to see how new deals progress when it has been so difficult to judge creditworthiness on the basis of 2020 earnings figures, particularly for any credits hit by negative rating agency adjustments.

EBITDAC adjustments were a noteworthy feature of loan and high yield bond deals through the year, with many borrowers and issuers relying on historical EBITDA numbers and/or data that excluded the impact of COVID-19.

Blackstone-backed measuring technology business Schenck Process, for example, added €5.4 million back to its profits in 2020 on the basis that it would have realised these profits had COVID-19 not struck.

German beauty retailer Douglas, meanwhile, added back €15 million to its earnings when reporting its second quarter results at the end of March, citing additional costs related to store closures.

The European Leveraged Finance Association (ELFA) has already voiced concerns about how EBITDAC has been applied.4 This raises questions about what LTM (last 12 months) numbers will be used, and how and when the market will transition back to standard EBITDA figures. How will dealmakers and lenders forecast and structure new deals? What happens to credits where covenants were waived? These are questions that the markets will be asking for months to come.

 

4. Pricing will continue to bifurcate by sector and rating

Borrowers in sectors hit particularly hard by lockdown measures—such as leisure, hospitality, aviation and automotive—were able to secure financing during the year, but at higher interest rates than those available to credits in favoured, more resilient sectors.

Cruise liner operator Carnival, for example, had to pay 12% for three-year secured bonds in the spring of 2020. By comparison, market research platform Nielsen launched a European term loan B offer a month later that was priced at just 3.75%.

Carnival announced plans in November 2020 to raise a US$1.6 billion unsecured bond priced at 8%, but this is still more expensive than the options available to companies in sectors like technology and healthcare.

The market also bifurcated when it came to ratings, with more than 90% of leveraged loan and high yield bond issuance coming from credits rated 'B' or above during 2020.

This 'flight to quality' could be the ultimate legacy of COVID-19, as lenders continue to analyse sectors and credits on a very granular basis in order to determine pricing levels and documentary terms.

 

5. Competition will encourage private debt and syndicated markets to converge

All indications are that high levels of liquidity will remain a feature of capital markets in 2021, which may lead to a wave of opportunistic M&A driven by available cash, as well as investing in distressed assets that are fundamentally sound but require capital. This dynamic is expected to drive up competition for transactions, pushing private debt funds to look at deals with increasingly borrower-friendly terms.

A blurring of lines between traditionally 'tight' private debt terms and 'permissive' distributed debt is on the horizon—with cov-lite possibly becoming the single product being accepted across the majority of the market.

The use of cov-lite and high yield-style incurrence covenants has spread through the large-cap and top-tier syndicated term loan market in the past five years and this product may now push on to cover the mid-cap and private debt market during the year ahead.

 

4 ELFA Insights vol 5. Nov 2020. European Leveraged Finance Association. PDF download.

 

 

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© 2021 White & Case LLP

 

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