Ten years on: The surprising resilience of European leveraged finance
The European leveraged finance market paused for breath in 2018 after two feverish years, but a combination of new money issuances for LBOs and the rise of CLOs has kept the market stable
After the shock of the financial crisis a decade ago, a new landscape emerged across debt markets and has continued to mature and develop over the past decade.
A boom in M&A activity over the past three years has boosted the market, with the volume of leveraged buyouts (LBOs) reaching levels seen pre-crisis—alongside the debt needed to fund the deals.
Investors, far from eschewing the riskier end of the lending spectrum, have been tempted up the yield curve, seeking out higher returns than those on offer in safer markets where quantitative easing has depressed yields. Encouraged by investors' desire for yield, riskier issuers/borrowers have started to demand looser terms on loans, knowing that investors, needing to deploy capital in competitive markets for deal allocations, would be more likely to accept.
For the moment, leveraged loans are in the ascendancy over high yield bonds, but large M&A deals in 2018 needed both sets of instruments to get across the line, with high yield bonds often required for that extra layer of debt. In addition, the continued growth of direct lending helped to provide financing packages that may not have been available in the syndicated or high yield markets. All the while, a backdrop of infrequent corporate defaults—assisted by low base rates—has comforted markets. Some pushback on pricing by investors was met by issuers, then reversed as the need for yield rebounded. In particular this year, investors have welcomed the return of syndicated debt instruments—2018 was a record year for collateralised loan obligations (CLO), with CLO markets breaking new issuance records in both the United States and Europe.
But if the leveraged debt markets have thrived in the post-crisis era, there are tough obstacles ahead. Geopolitical issues such as Brexit; global trade wars; Italian sovereign debt; volatility in the stock market; and a concern that default rates, low for so long, might begin to trend upwards have given the market pause. Underpinning everything is the US Federal Reserve, which is already leading the way in raising interest rates. The impact of increased borrowing costs is set to echo further afield—and could push other central banks to keep pace or react to the impact it causes.
However, despite uncertainty about what lies ahead, the market remains resilient and deals are still getting done. Ten years on from the darkest days of the crisis, the leveraged debt market has proven surprisingly resilient, but bumps may lie on the road ahead.
As noted in the report, times have changed, and 2018 has seen a different dynamic than in the previous two years. The rise in US interest rates has had a significant impact on the market, with the move from bonds to loans speeding up and the pace of refinancing activity slowing markedly.
In addition to those shifting dynamics, macroeconomic and political factors such as Brexit, further interest rate rises and continued volatility in a number of EU markets could all have a bearing on the market and drive its development for the year ahead. While it's difficult to chart an exact course, there are several tendencies that may play out and, indeed, possibly co-exist in 2019.
A deep and mature market
While economic volatility and events such as Brexit could hurt issuance levels, the market has evolved in the past decade into a robust and diversified market that caters to the needs of a variety of lenders and borrowers. There are more products and more options available than ever before, and it is difficult to predict which of those will be in the ascendancy in 2019.
Acquisition and LBO financing should continue to account for a large share of issuances in 2019; most issuers that want to refinance have already done so. A strong M&A pipeline, corporate portfolio management in response to changing economic times and a surfeit of dry powder at private equity funds may well keep the leveraged debt market going. Meanwhile, demand from investors will likely sustain the issuance for the foreseeable future.
The renewed growth of CLOs also look set to keep refreshing bank balance sheets as investors seek yield. This should ensure the flow of capital continues until interest rate increases hit underlying issuers and potentially cause investors to return to safe havens.
And if interest rates stabilise, demand for fixed rate instruments could begin to reassert itself and we could find bonds coming to the fore once again.
A test for funding providers
The broadening of the leveraged finance market to include asset managers and other debt providers has been a notable development in the post-crisis world. They have stepped into the breach at times when banks have been in retreat, succeeded in gathering assets and become a key part of the lending ecosystem—but that is only half the battle. As a relatively new phenomenon, certainly at such scale, direct lenders and relevant debt providers have not been tested in a true market downturn. That test may emerge in 2019.
With billions in capital to put to work, they have entered deals at pace and often with high leverage levels. Should the market hiccup or hit a severe correction, many investors in these funds may find their holdings with lower recoveries than other leveraged finance sectors.
Watch for defaults
One development that has the potential to destabilise the market would be a marked increase in default rates. The continued supremacy of cov-lite could be delaying defaults and shielding poor credits.
So far, the story has been that if the covenant is not there to breach, there is no danger of default. With interest rates as low as they have been, it has been hard for companies to run into difficulties outside of a liquidity crisis, as there are no covenants that give lenders an early trigger. However, should economic conditions worsen or interest rates rise further, default rates could spike.
It may take just a couple of distressed situations in which a lender loses its investment to shake investor confidence in the burgeoning new market. This could have a knock-on effect for those accepting the looser terms in the term loan B market.
The Bank of England Financial Policy Committee has expressed concern about the rapid growth of leveraged loans and pointed out just how far lending terms had loosened in the UK, with maintenance covenants currently featuring in only approximately 20 per cent of loans versus close to 100 per cent in 2010. The IMF is the latest to voice its concern: "With interest rates extremely low for years and with ample money flowing through the financial system, yield-hungry investors are tolerating ever-higher levels of risk and betting on financial instruments that, in less speculative times, they might sensibly shun."
With a more diverse range of financial products, it is less clear where the risk in the market ultimately lies. We saw with the US sub-prime crisis that risk in the market can be concentrated in unexpected locations. As investors have been chasing yield for the past decade, an unexpected downturn in the leveraged finance market could ricochet into other areas and compound any slowdowns.
With so many factors in play, market participants will be reluctant to make any hard and fast predictions for 2019. However, if history is any guide, the market is likely to continue to evolve to meet the needs of issuers and borrowers and, macroeconomic shocks aside, will continue to offer a wide range of options for all participants.