It’s official: Leveraged loans are back in Europe and they are here to stay.
Recent deals in the leveraged finance space for companies such as Gala Coral Gaming Co. have featured healthy loan segments, and have, according to a senior leveraged finance banker in London, underscored the fact that the European loan market, as many had predicted at the beginning of this year, is continuing to progress and return to some sense of normalcy.
“We are getting inquiries on deals that are percolating and the number of discussions about loans is growing,” the banker said.
The European loan market is in a good situation now, with a steady supply of well structured deals, and it looks set to continue to strike a good balance between supply and demand, said Matthew Craston, head of alternative investments at European Credit Management (ECM) in London.
While the pipeline of new loan deals still consists mainly of refinancings of legacy transactions, there are nevertheless a number of new issues coming from the private equity side of the market as buyouts increase, said Zak Summerscale, managing director and head of portfolio management and trading at Babson Capital in London. Going forward, new issuance will gain further momentum because of the role that private equity is playing in Europe, he said.
“We’ve seen the U.S. loan market quite strong over the past year and now in Europe, it looks as though we are finally starting to catch up,” Summerscale said. “We have raised significant amounts of cash in our institutional loan fund and this is filling up the void left by existing CLOs, that can still reinvest, but we haven’t seen any new CLOs.”
As The CLOs Turn
In the years leading up the financial crisis, CLOs had formed the bedrock of the institutional investor base for leveraged loans in Europe. As in the U.S., European CLOs are flush with prepayments right now and as such, are “forced buyers” of loans in the short-term, Craston said. “The European market doesn’t also have the retail interest in loans, and the CLOs should be seen as providing helpful support to the new issue market, and in periods when issuance slows, to secondary loan market prices.”
But despite European CLOs recouping repayments over the past few months, their future presence in Europe has been the subject of debate and discussion, and some are concerned that a lack of new CLOs will have an impact on the flow of new loan issuance.
Even though loan issuance will continue to pick up in the second half of the year, but the extent to which it does will depend on the existing stock of CLOs said Paul Watters, head of corporate research at Standard and Poor’s in London. “There is liquidity in these vehicles now to support refinancings and new deals, but it is unlikely to last as most of the existing CLOs will be reaching their reinvestment period soon, and that raises serious questions as to whether and how these funds could extend their lives or reinvest unscheduled payments,” Watters said.
According to Craston, CLOs will only play a supporting role in the market for the next 12 months or so, since “they won’t be able to reinvest prepayments forever.” As such, CLO influence on the new issue market will eventually wane, he said, but the silver lining is that as this occurs, CLOs will be replaced by fund investors, who are showing increasing interest in the loan asset class.
“We’re at a good juncture in the market now, with the CLOs providing good support while the market witnesses every increasing participation from other investors – people who may no longer want exposure to loans through structured credit vehicles, but have seen that the asset class has performed well in terms of fundamentals and wish to get exposure to it through other vehicles such as loan funds,” Craston said.
Sources also believe that one of the most important factors supporting the European leveraged finance market is that debt financings, private equity in particular, are not relying only on leveraged loans. While they were the instrument of choice prior to the crisis and it is still imperative for companies to have senior debt at the top of their capital structures, most large transactions coming to the European leveraged finance market today include both loans and high yield bonds, senior secured as well as subordinated.
“Issuers do need a subordinated piece and high yield continues to be an attractive market, especially because mezzanine market is not what it used to be,” Summerscale said. “We are certainly being talked to a lot about private equity’s appetite for high yield.”
HY To The Rescue
The senior secured high yield bond in particular has really become an instrument of choice for issuers in Europe and has proven itself to be extremely popular. These bonds are filling the vacuum left by CLOs, Summerscale said. Babson Capital has two dedicated senior secured high yield bond funds, launched when that market was staring to get going and for which the firm was able to raise over $600 million in cash over the past two years.
Overall, though, 2011 has continued to be a high yield bond story, with bonds—particularly senior secured high yield bonds—dominating the European leveraged finance landscape. Forthcoming deals will feature both loans and bonds, Watters said, not least because private equity sponsors are making better use of the high yield asset class.
However, the macro uncertainty surrounding the Eurozone is still very real and the continued positive momentum of the markets hinges on it.
“Europe appears rather like a jigsaw puzzle, with banks in the north more liquid and willing to lend more, while high yield bonds are playing a greater role elsewhere, including in more challenged jurisdictions such as Spain,” Watters said. “It’s clear that across Europe, mid-market corporates want to term out their debt and refinance with long-term rates that are at relatively low levels. But one could argue that much of the issuance has been front-end loaded, because there is still a great deal of uncertainty across Europe and we are still looking at sub-par growth in the Eurozone.”