European leveraged finance: A bifurcated balancing act
Growth in the European leveraged finance market remained steady in 2019, with 2020 set to continue at pace, with enhanced focus on the trade-off of protection from risk versus a higher yield
A new decade starts with optimism and a strong pipeline, to build on the resilience of an ever-maturing market.
As we enter the new decade, the resilient European leveraged finance market continues to grow and mature. The market is agile and has continued to deal with significant changes, ranging from the mix of leveraged loans and high yield bonds to the impact of direct lenders, sectoral and regional changes, as well as politics across Europe, including considerations relating to Brexit.
Against that backdrop, we begin 2020 with a pipeline of approximately €36 billion, nearly 70 per cent higher than 2019, year-on-year. Pricing is at an attractive level for borrowers, with the lowest high yield bond pricing levels for new issues in recent times; cov-lite has taken hold of the market; restructurings are at low levels; and a platform for social change, led by the UN Sustainable Development Goals, environmental, social and governance standards and investor sentiment, all point towards great market potential.
These trends are also penetrating more sectors, regions and deal types, as several countries see ‘deal firsts’ as trends flow across borders, and leveraged finance processes support alternative deal structures from traditional LBOs, to move into, for instance, the public-to-private space, with increasing pace.
Still, potential bumps in the road—central bank action causing interest rate hikes, the impact of the coronavirus outbreak (both in China and globally), full details of Brexit and the finalisation of trade deals across the globe—will all have details which will affect the market, but the market is better placed than ever to deal with these factors, as industry professionals put to work their experience of recent years in growing the market to good effect.
Data dive: European leveraged finance 2020
The covenant-lite share of European institutional loan issuance in 2019 reached 92 per cent
European leveraged loan issuance in 2019 was down slightly on the previous year to €209.1 billion
High yield bond issuance jumped more than 20 per cent to €95.5 billion
Regional focus: Spain finishes strong by Fernando Navarro, Partner, White & Case
The Spanish leveraged finance market went from strength-to strength in 2019, with a selection of large deals and the market’s capacity to execute complex deal structures pushing issuance to four-year highs.
High yield offered few surprises in 2019, but the leveraged finance market in Spain has enjoyed a particularly good year, boosted by several larger deals and significant activity in the mid-market, which is the biggest market in the country. The market has matured, grown
more sophisticated and, as far as investors are concerned, is more closely aligned with Western European trends than ever before.
By the end of 2019, Spanish leveraged finance issuance (loans and high yield) totalled €27.7 billion across 64 deals. This was well ahead of the €15.7 billion issued during all of 2018 and the €20.7 billion of issuance in 2017.
The market’s maturity is evidenced by pricing in Spain, where spreads have narrowed. In 2014, institutional Spanish loans were priced at 389 basis points (bps) versus 424 bps in the UK, 410 bps in France and 416 bps in Germany, according to Debtwire Par data. In 2019, Spanish loans were pricing at 342 bps on average, versus 381 bps in the UK, 407 bps in France and 396 bps in Germany.
The growth of Spain’s market is further reflected in the big-ticket deals the market has been able to digest and deliver.
KKR’s €602.23 million (US$667.5 million) take-private of pizza group Telepizza, for example, saw the investment firm start out with a standard bridge loan and revolving credit facility, with a view to refinance the whole facility through a €333.8 million (US$370 million) high yield bond priced at 6.25 per cent, according to Debtwire Par.
This deal was particularly notable in that the bridge loan was subject to English law, while the covenant package was subject to New York law. A few years ago, the Spanish market would have found it difficult to understand a complex structure like this. In today’s more sophisticated market, deals like these are no longer unusual.
Grifols is another prime example: The pharmaceuticals group secured a refinancing involving a term loan B (TLB) that sat alongside a high yield bond and a super-senior revolving credit facility. Spanish telecoms group MásMóvil, meanwhile, sought to refinance a convertible bond and simultaneously increase its debt in 2019 by combining a covenantlite loan with the issue of preferred equity.
While TLB structures were considered better suited to London and New York a few years ago, they are now viewed as another viable source of financing by banks and borrowers in Spain.
Spain enters new territory
Deal momentum is expected to carry the market in 2020, with airline operator IAG’s €1 billion (US$1.11 billion) acquisition of Air Europa and a bidding war for Spanish Stock Exchange group BME both expected to tap into leveraged markets.
Despite the positive outlook and cov-lite characteristics of loan issuance, however, an uptick in restructuring activity is anticipated. Deals like the €1.8 billion (US$2 billion) issue for supermarket cooperative Eroski have already made a telling contribution to restructuring values. With the Spanish Socialist Workers’ Party winning the most seats in the November 2019 general election, rising taxes are also a distinct possibility and could weigh on both consumer spending and corporate cash flows
While acquisitions are in the pipeline, the market may see more restructurings by Q3 and Q4 2020, running in parallel with acquisitions. This is new territory for Spain, and should make for an interesting year ahead.
"The leveraged finance market in Spain has enjoyed a particularly good year, boosted by several larger deals and significant activity in the mid-market, which is the biggest market in the country."
Sector watch: Hot or not?
Industrials and chemicals in aggregate accounted for the largest share of loan activity (20 per cent) and high yield bonds (22 per cent) in Europe
Pharma, medical and biotech issuers were the second most active in European leveraged loans, (14 per cent of deals in aggregate)
Services topped the list for loans in Europe with 11.2 per cent of issuances for the region
In a market that has seen notable highs and lows since the financial crisis, while remaining ever-vigilant for red flags, a degree of consistency is beginning to take hold in European leveraged finance
Default levels remain historically low at 1 per cent to 2 per cent
Prevalence of cov-lite loans in Europe may be concealing some underperformance, but there are no conventional triggers for lenders to act
Despite concerns that the economic cycle is peaking, and the impact of geopolitical and trade volatility on corporate earnings, leveraged finance default rates show little sign of rising during the next 12 months.
According to Debtwire Par, loan buysiders do not expect to see defaults spike as levels hold steady in the historically low 1 per cent to 2 per cent range. With interest rates in the UK and Europe expected to remain low, and more than 90 per cent of European institutional loans issued on cov-lite terms in 2019, lenders have little scope to step in when credits show signs of underperformance. This has resulted in a relative lack of restructuring negotiations regarding leveraged loans and high yield bonds, despite growing macroeconomic concerns and uncertainties around borrowers' ability to refinance loans in the medium to long term.
Restructuring activity has occurred in some sectors, including shipping, retail, casual dining and leisure, but the persistent low interest rate environment has contributed to relatively benign conditions for borrowers.
Signs indicate, however, that more financial distress is creeping into the system, especially in the United States, where developments can foreshadow events for Europe.
Clouds on the horizon?
According to Goldman Sachs, high yield bond defaults topped 5 per cent in 2019, up from just 1.8 per cent a year ago.5 Meanwhile, the EY Profit Warning Stress Index, which tracks the number of profit warnings issued by UK-listed companies, recorded 313 profit warnings in 2019, the highest total for profit warnings since 2015. Of the companies tracked, 17.8 per cent issued warnings last year, which represents the highest percentage of businesses to do so in a year since 2008.6
The absence of covenants, however, means that borrowers may choose to act only if their loans are approaching maturity or they are running out of cash. As much of the loan and bond issuance from recent years is long-dated, and traditional levers to commence restructuring discussions are often unavailable, lenders concerned about the health of the credits in their portfolios are forced to adopt a more creative approach when borrowers show signs of distress.
Revolving credit may open doors
Revolving credit facilities (RCFs), which have typically retained financial maintenance covenants, are one potential way to exert influence. In practice, RCF covenants will often only come into play on a 'springing' basis, when the RCF has been drawn to a meaningful level. But should the company become more stressed, it is likely to turn to the RCF and other sources of liquidity, and the financial covenant may become relevant.
Other creditors in the company's capital structure may find this comforting, but it is very different from having direct covenants, as would have been the case in previous generations of loan documents. Borrowers often find ways to manipulate their cashflows to avoid tripping the springing covenants, even in relatively distressed circumstances. If they cannot avoid a breach, they may be able to negotiate a separate waiver with the RCF lenders that leaves the term lenders and other creditors on the sidelines.
Degrees of proactivity
Some lenders, absent conventional default triggers, have looked to take steps to challenge directors of distressed borrowers, taking a more interventionist approach if they feel it necessary and reminding directors of their fiduciary duties, as well as querying whether the action being taken is in the best interest of the company's stakeholders.
Not all sponsors and management teams will allow things to go this far, however, and more creative sponsors may look to step in early and work alongside lenders to deliver solutions proactively. This strategy can be very effective in the right climate, as sponsors will typically have considerably more negotiating power as to a portfolio company that is not in breach of its loan documents than they might otherwise have later in the cycle when default is unavoidable or has already arisen.
Factors such as the nature of the capital structure and the mix of creditors, the health of the underlying business and the sponsor's stance will determine a borrower's willingness to come forward. In some cases, a borrower's simple act of commencing a restructuring dialogue with its lenders can act as an unwanted catalyst and precipitate a deterioration in the business, making borrowers and sponsors alike wary of instigating discussions prematurely.
That said, coming to the table early may be the smart course of action and create enough of a runway for the sponsor and the management team to present a turnaround strategy to the lenders and agree on the framework within which it can be realised.