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European leveraged finance: COVID-19 and the flight to quality
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Living dangerously: How has European leveraged finance fared in the pandemic?

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

 

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