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

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

Insight
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8 min read

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HEADLINES

  • 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

After a volatile year, European leveraged finance markets sparked back into life in the final quarter of 2020, proving more resilient than many anticipated and well positioned to continue building momentum.

Going into 2021, many of the elements that characterised leveraged finance issuance during the COVID-19 pandemic are likely to remain a feature of the market. For example, in the short-term at least, lenders will continue leaning towards high-quality credits or those in sectors that have seen COVID-19-linked opportunities for growth, such as technology and healthcare.

For borrowers that meet the criteria, the ongoing market recovery and appetite among lenders to catch up on lagging deployment schedules will support the ongoing march of flexible documentation and light-touch covenant packages that were typical pre-pandemic.

For example, the carve-out of ThyssenKrupp's elevator business, led by buyout firms Advent and Cinven as well as Germany's RAG Foundation, secured a package of loan and debt financing in June 2020 on borrower-friendly terms, including a cap of 25% on EBITDA adjustments, a 45-day holiday on ticking fees (i.e., fees charged on undrawn debt facilities) and scope to raise additional leverage.

11%+
The rise in leveraged loan issuance in 2020, year-on-year

 

Positive signs

Despite a severe market dislocation in March and April, overall European leveraged loan issuance reached €227.1 billion for the year, up on the €204.5 billion recorded in 2019, according to Debtwire Par, although institutional loan issuance did see a larger decline, dropping 22% to €90.9 billion over the same period. High yield bond issuance has proven more resilient—up 10% on 2019 figures to €100.5 billion— and could well retain the market share won from loans through the course of 2020, especially lower down the capital structure, with unsecured high yield bonds pricing competitively against second-lien loan debt.

Pricing on loans and bonds widened in 2020 and, despite tightening in the final quarter of the year, lenders expect to see pricing hold in their favour in the months ahead, as fewer opportunistic credits hit the market for a repricing than seen in prior periods.

Average yields to maturity on high yield bonds widened from 3.8% to 4.7% through the course of the year, while the average margins on institutional leveraged loans increased from 338 bps in Q1 2020 to 401 bps in Q4.

There are several examples of deals that were able to raise finance but at higher pricing, including BlackRockowned Creed Fragrances, which priced a €250 million institutional loan at 5% over Euribor, and Blackstonebacked Building Materials Europe, which secured a €220 million refinancing at the same cost.

In the loan markets, lenders secured further pricing enhancements through deeper original-issue discounts (OIDs—the discount from par value at which a loan is offered for sale to investors) and, in some cases, improved LIBOR floors. The share of new loans with OIDs of 99 and below increased through the year, representing more than a quarter of new deals.

With regards to LIBOR floors, which lock in a minimum interest rate for borrowers even when interbank lending rates fall, the share of loans with floors of between 0.5% and 1% increased slightly in 2020, although 0% floors do still account for the bulk of issuance.


 

Reasons for optimism

While a second or third wave of COVID-19 poses ongoing challenges for the market, a series of approved vaccines with ongoing rollouts, along with a change in administration in the US, have raised hopes for improved deal flow in 2021. Vast quantitative easing programmes introduced by the Bank of England and the European Central Bank have injected large sums of liquidity into capital markets, which will be put to work by banks and investors.

Additional European government employment support schemes— which received applications from more than 40 million workers—and various state-backed loan schemes brought further liquidity into the marketplace when it was most needed, injecting billions into European economies.

These measures, combined with low interest rates, have allowed many lenders to get their capital deployment targets back on track.

Government and central bank action also supported existing credits through the most volatile stages of the year, which meant that many borrowers could avoid restructuring scenarios. As a result, only €3.1 billion of leveraged loan issuance was secured for restructuring in 2020. Restructuring activity, however, could still increase as government support measures unwind.

An anticipated recovery in mergers and acquisitions (M&A) and leveraged buyout (LBO) activity will provide an additional lift in the early months of 2021. Leveraged loan issuance for M&A (excluding LBOs) rose 26% year-on-year to €46 billion, according to Debtwire Par, while LBO loan issuance was down by 6% to €36.8 billion.

These shifts in issuance align with a wider M&A slowdown during the year. Mergermarket data shows that European M&A deal count fell 29% between Q1 and Q2 of 2020. However, M&A rebounded in the second half of the year, with deal values finishing the year up overall on 2019. LBO deal values followed a similar path, according to Debtwire Par, but deals started to pick up towards the end of the year.

 

COVID-19 trends

The rise in M&A coupled with pent-up lender demand make for a positive outlook for leveraged finance activity going into 2021. This stands in stark contrast to the uncertainty the market faced when the spread of COVID-19 accelerated and lockdowns first came into force across Europe. Leveraged loan issuance almost halved between February and March 2020. European high yield bond markets shut down entirely, with almost zero issuance in March.

Secondary markets revealed further indicators of distress. In February, existing loans were pricing at an average of 97.4 (% to par) according to Debtwire Par. A month later, average prices in the secondary market had fallen to 82.3 (% to par), with 99.8% of all European loans in circulation suffering declines in face value, compared to 32% in January.


Against this challenging backdrop, new loan activity dried up. Liquidity became the primary focus for borrowers, who drew down on existing facilities and sponsors directed resources into portfolio management. According to data quoted in the Financial Times, at least 104 European non-investment-grade borrowers drew down around €32.2 billion from loan facilities through the first wave of COVID-19 lockdowns.1 This, plus central bank and government stimulus as well as higher secondary market prices, prompted a marked rebound in high yield activity towards the middle of the year—June saw more than a five-fold month-on-month increase in issuance, jumping from €2.9 billion in May to €16.2 billion.

With billions drawn down from existing facilities held by banks, bank balance sheets were extended. Deeper investor pools made high yield an attractive option for borrowers eager to lock in liquidity.

For lenders, a number of ratings downgrades as a direct result of COVID-19 saw a notable increase in 'fallen angels'—bond credits that lose their investment-grade status after a downgrade.

The underlying quality of these credits appealed to high yield investors. In September 2020, S&P Global reported that fallen angel issuance was on track to reach a record high of around US$640 billion (€527.4 billion) in 2020.2 And as mentioned above, pricing also moved in favour of high yield investors, drawing more to the bond market. This showed that investors recognised that fallen angels remained good-quality credits with strong cash flows and attractive assets, though the financing structures may have had to introduce a set (or sub-set) of high yield covenants or may have required collateral to support the debt.

The focus on liquidity and on the management of portfolio assets by private equity also meant that most issuance was used for refinancing or general corporate purposes. Refinancing accounted for €74.7 billion of loan issuance in 2020, with €53 billion secured for general corporate purposes. LBOs and acquisitions amassed €36.8 billion and €40.8 billion respectively.

High yield has followed a similar pattern, with refinancing (€49.6 billion) and general corporate issuance (€13 billion) outpacing issuance for LBOs (€7.8 billion) and acquisitions (€9.3 billion).

The recovery in secondary prices as 2020 drew to a close is expected to support ongoing issuance for refinancing and general corporate purposes, with prospects for LBO issuance also upbeat.

Average secondary market institutional loan pricing recovered to more than 95% in December 2020, according to Debtwire Par. and even credits in the sectors directly impacted by lockdowns saw secondary pricing rebound. Cineworld, Hotelbeds and Vue Cinemas, for example, all enjoyed double-digit increases in secondary market pricing in Q4 2020.

 

Looking ahead

While COVID-19 sharpened the market's focus on liquidity and portfolio management, it amplified another trend that will carry into the year ahead: the increasing focus on environmental, social and governance (ESG) criteria in leveraged finance.

The pandemic has demonstrated—in the starkest possible terms—that businesses are not isolated from social and environmental factors. Institutional investors across all asset classes are recognising this fact and are increasingly adding an ESG filter to their criteria. Signatories to the UN Principles for Responsible Investment have grown from 100 when the organisation first launched in 2006 to more than 3,000 today.3

European leveraged finance markets still have work to do in this area, but they are clearly catching up with other asset classes, with an increase in working groups across many organisations tasked with deepening the understanding and implementation of ESG matters. There are also examples of loan documentation including provisions that give lenders a higher margin if agreed ESG criteria are not met, with a margin discount applying where such criteria are satisfied.

This theme should continue to gain traction in post-COVID-19 leveraged finance markets as investors and lenders alike pay greater attention to ESG metrics.

 

"Riskier European companies draw €32bn from bank credit lines". Anna Gross. 27  May 2020. The FT.
"Global 'fallen angel' debt on track to reach record high in 2020 – S&P". Peter Brennan. 2 Sept 2020. S&P Global.
3. "Principles for Responsible Investment". About the PRI.

 

 

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© 2021 White & Case LLP

 

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