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European leveraged debt lifts off

What's inside

Loans and high yield bonds make a comeback as economic vitality breeds confidence among investors and issuers

Leveraged debt is alive and kicking

It has been a banner year for the leveraged debt markets, and despite a number of political and economic headwinds, 2018 could be even stronger.

As we enter a new year, we are happy to report that the leveraged finance market is flourishing in Europe and the rest of the world. This welcome news comes after a disappointing 2016 and an uncertain start to 2017.

And it is even more welcome against a backdrop of geopolitical uncertainty across the world. Fortunately, the global economy has been more benign, with the US and EU showing growth and many emerging economies strengthening.

As we predicted in the previous issue of our report, the ongoing competition for market position between the covenant-lite term loan B and high yield bonds continues. The term loan B had a strong start to the year, although high yield caught up later in 2017 with a surprising surge. High yield had a momentary pause in the third quarter, as market participants caught their breath from the robust round of activity, but the fourth quarter saw a renewed uplift.

Convergence, which has been a long -running theme in all of our annual reports, continues unabated. In 2017, the meeting of the minds between the US and Europe has taken the form of both regions seemingly trying to outdo each other in the covenant flexibility or covenant erosion realm, depending on your point of view.

And what of the year ahead? There is every reason to believe that the trends seen in 2017 will continue—at least, in the short term. However, there could well be headwinds, as geopolitical uncertainties exert their influence. MIFID II, new ECB regulations, Brexit and interest rate increases could weigh heavily on EMEA markets in 2018. However, attention will be on the developments in the US where there is talk of deregulation under the Trump Administration, which runs counter to the continuing tightening regulatory environment in Europe.

On a positive note, buy-side demand remains strong with sell-side assets available. As a result, we can expect a combination of refinancings; private equity and acquisition-based lending; and opportunistic (including dividend) new money deals. There should also be interesting prospects in a more settled high yield market, a bridge-to-bond and term loan B product mix as well as the more traditional European bank financing structures. Other financial products, such as asset-backed securitisations, are expected to add to this diversity of options, and an optimist may even argue that adapting to new regulation will create new opportunities.

 

Rob Mathews
Partner, London

Lee Cullinane
Partner, London

 

Leveraged debt storms back in 2017

  • Leveraged loan value outstripped 2016 level by €131.3 billion in 2017
  • Value of high yield bonds has surpassed 2016 by 32 percent
  • Refinancing and repricing drive the market
  • Leveraged loans continue primacy over high yield bonds
Frankfurt city downtown

Issuers in the driving seat

  • Average size of leveraged loan increases significantly
  • Weighted margin of first-lien loan drops to lowest level in years
  • Term loan B issuance outstripped 2016 levels within the first three quarters of 2017
  • Cov-lite deals march on
Old building at Zurich Switzerland

European leveraged debt in focus

Selected European leveraged loan and high yield bond markets by volume


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The future for European leveraged debt

Economies are strengthening and the outlook is probably the best it has been in 10 years, but there can be no room for complacency in the debt market

Place Vendome, Paris

European leveraged debt lifts off

White & Case partners Rob Mathews and Lee Cullinane explain how 2017 was a banner year for loans and high yield bonds in Europe and discuss the strong prospects for European leveraged debt markets in 2018.

The future for European leveraged debt

Insight
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5 min read

Although there will be turbulence next year, the big difference is the improved global economic picture. This is reflected in the IMF's November report, which raised growth forecasts to 3.6 percent this year and 3.7 percent in 2018.

Economies are strengthening and the outlook is probably the best it has been in 10 years, but there can be no room for complacency in the debt market

The momentum is set to continue into 2018, although the dynamics could change on the back of rising interest rates in the US and UK. The steady stream of refinancings could ebb, although the European loan market is expected to remain an attractive market because the ECB has no plans to raise interest rates until mid-2019. It is gradually halving its monthly bond buying programme to €30 billion, which means there will still be plenty of liquidity in the system.

 

Solid fundamentals

However, any slowdown in refinancing is likely to be offset by a robust pipeline of M&A deal flow; strong CLO demand; broad investor appetite for leveraged loans; and a positive macroeconomic outlook across most of Europe, according to a report from Moody's released in November. In addition, the liquidity profile in the EMEA non-investment-grade universe should be solid next year, while the European default rate is likely to stay below 2 percent. This is due to improving credit quality, positive economic fundamentals and industry outlooks. Other contributing factors include low refinancing risks, stability in commodity prices and a relatively low high-yield spread. There may be defaults, but they will be isolated and occur among companies vulnerable to event risks or in weak sectors.

Market participants are also optimistic on the outlook for both US and European high yield debt due to an improving global economy, which has increased the likelihood of more upgrades than downgrades in ratings.

 

New rules

Regulations could take their toll, especially the ECB's guidance on leveraged transactions, which is being introduced to rein in risky bank lending and is similar to the US Leveraged Lending Guidelines introduced in 2013. While some details are clear, including the definition of leveraged transactions as all types of loans or credit exposure with leverage of more than four times total debt to EBITDA, many questions are still outstanding. The most notable are the definition of total debt and the impact of the regulation on acquisition finance and banks' internal systems due to the introduction of a stricter 90-day limit for syndicating deals.

In addition, concerns persist over the statement that highly leveraged loans with leverage of six times total debt to EBITDA should remain exceptional, because many loans could fall into this category without further clarification.

One of the main issues is that the rules could create an uneven playing field in the leveraged finance space. For example, European central banks may put their own spin on the interpretation and implementation, while a disproportionately large number of higher leveraged transactions could be undertaken by banks not governed by the ECB's guidance. These range from institutions that do not participate in the Single Supervisory Mechanism (SSM) to those that are not regarded as 'significant' by the ECB and non-bank lenders. If this scenario materialises, it is unclear how regulators and supervisors will react. However, it is unlikely that the ECB would expand the number of institutions it regulates.

 

An optimistic outlook

Although there could be political headwinds next year, the big difference is the improved global economic picture. This is reflected in the IMF's October report, which raised forecasts for global growth to 3.6 percent this year and 3.7 percent emerging Asia, emerging Europe and Russia.

The picture has not been this positive in Europe for ten years. Leveraged loans and high yield bonds will also benefit from strong investor appetite, low default rates, improved industry outlooks and a relatively low high yield spread.

Demand is expected to remain firm for loans, as the Federal Reserve lifts interest rates further and central banks begin winding down stimulus. However, in the US, all eyes will be on the possible repeal of the US Leveraged Lending Guidelines, which were implemented in 2013 to curb systematic risk in the banking sector by limiting their ability to underwrite highly leveraged loans. Yet this did not dampen investor appetite, and there is a view that relaxing the regulations could shift underwriting volume back to the investment banks, which potentially could lead to larger M&A-related loans.

 

 

 

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© 2018 White & Case LLP

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