The co-head of global leveraged finance at Credit Suisse tells Geraldine Lambe that the leveraged party isn’t over yet and that targeted investors should cushion a downturn.

Since the middle of 2006, pundits have been predicting the turn in the credit cycle; a sell-off is inevitable, they say, because volumes and returns are unsustainable; and surely the leveraged sector in particular is heading for a fall. But it has not happened yet. In the year to date, European high yield has returned 3.23%. “That is a very good return for any fixed income class,” says Jim Amine, co-head of global leveraged finance, who last month was appointed sole head of the global markets solutions group in Europe at Credit Suisse. “If you had sold when the market had its first correction, then you would have missed that tightening.”

Such is life in the markets: nobody wants to jump off the rollercoaster too early for fear of missing out on the rest of the ride. If volumes and returns seem untenable and other market signals – such as sub-prime woes in the US – point to the end of the benign credit cycle, then the sheer wall of money that still has to be put to work does not. In 2003, private equity funds raised $49bn; last year that figure rose to $215bn, according to Private Equity Analyst. Assume that equity capital constitutes about 20% of the capital structure and you get a sense of the transaction volumes that the leveraged finance markets are expecting.

The volume story

In 2004, sponsor-backed deal volume was a record $490bn; in 2006 it rocketed to $840bn. That figure had already been surpassed by the beginning of May this year. Add to that the liquidity represented by the growth of collateralised loan obligations (from $55.9bn to $265bn between 2000 and 2006), event-driven hedge funds ($33.5bn to $193bn) and distressed hedge funds ($7.9bn to $62.8bn) and it is clear that market technicals are propping up volumes.

Corporates, too, are playing a growing role in leveraged finance volumes, fed in part by the explosion in debt-financed acquisitions over the past 18 months to two years, and by corporates’ growing understanding of the benefits and flexibility offered by leveraged instruments.

Credit Suisse, which has doubled its leveraged finance revenues in the past two years, was the first investment bank to form a dedicated group to go after corporate leveraged finance business three years ago; it currently boasts a 25% market share of the corporate high yield bond market.

“To a certain degree, corporate volumes are acquisition driven, so the mergers and acquisitions cycle dictates how quickly market volumes can grow, but there other signs of growing corporate activity,” says Mr Amine. “Clients increasingly understand that in a refinancing or restructuring of their balance sheet, the use of leveraged finance can be extremely cost effective.”

Every leveraged product is growing massively but there is more growth in loans than in bonds, driven by lower transaction costs and the growth of the ‘covenant-lite’ market (see graph below).

“A number of recent financings have been done without bonds – typically with bank, second lien and mezzanine financing, or just bank and second lien; and that trend will continue,” says Mr Amine. “The average hold period for sponsors’ portfolios in Europe has gone from about 3.5 years to about 18 months, so it would be too expensive to refinance bonds where there is four or five years’ call protection.”

Fall of mezz, rise of cov-lite

Mezzanine volumes have declined. At the end of last year, most people predicted that mezzanine (a hybrid of debt and equity financing that gives the lender the right to convert to ownership or an equity interest in the company if the loan is not paid back in full and on time) would have another record year in 2007, but volumes were down substantially in the first quarter. Mr Amine says there has been a “substitution” effect.

“The capital structure has been stretched – using first and second lien [debt that is subordinate to more senior debt tranches against the same collateral], and in some cases PIKs [payment in kind, typically a type of bond that pays interest in additional bonds, as opposed to cash] – meaning that the blended cost of capital for issuers is now lower without mezzanine than with it. And a number of transactions have been able to get the same leverage without putting in a more expensive mezzanine tranche.”

The covenant-lite market, in which many of the protective clauses that enabled lenders to track risky loans and declare borrowers in default if they were breached have been removed, is also on the rise, going from $2.4bn to $23.6bn outstanding in 2006.

“Some companies have entirely replaced bank debt with floating rate notes [FRNs] with no maintenance covenants,” says Mr Amine. “Given the levels of leverage they are running, borrowers now see the opportunity to make the capital structure more robust.”

Too much ‘headroom’?

In addition to encouraging the removal of covenants, liquidity is also allowing borrowers to refinance, defer interest or principal amortisation; all the actions that often used to trigger default. At the same time, covenant ‘headroom’ – the tolerance for underperformance over and above the minimum Ebitda (earnings before interest, taxes, depreciation and amortisation) requirements laid out in a corporate’s business plan – is growing; some corporates would now have to underperform quite substantially (by about 20%, suggests Mr Amine) before they tripped a default.

With five times as much debt (bonds and loans) outstanding as in 1990, many fear that such technical aspects are keeping default rates at artificially low levels.

Mr Amine says that, although there is some truth in this, when default rates do rise (which he believes will not happen until the back end of 2008), liquidity, just as it is shaping the market now, will be the key determinant in a downturn. And he maintains that the huge growth in the number and type of market participants will go a long way to making a market correction less severe.

“When a credit cycle turns, what most people want is the ability to sell when they want to sell. And there are now so many participants focused on different strata within the capital structure – par, stressed, distressed – that you can now find an investor for every piece of the chain. These different pools of capital will help to maintain liquidity in the next down-draft,” he says.

This kind of specificity is also mirrored in the new kinds of products being created. Innovation is not just about putting higher leverage on a credit, it is more about providing greater flexibility and tailoring products to issuers’ and investors’ needs, says Mr Amine.

Innovation around the tranching of debt, where they can appeal to different investor classes, enables banks to tailor a capital structure at the same time as driving down prices for issuers. “The reason is that you can slice up the capital structure to appeal to investors who just want that piece, and are willing to take less of a return because that is exactly the piece they want,” he says. “That has been done very creatively around the market. One example is FRNs. Many bond investors are happy to take on exposure without maintenance covenants, specifically because of where FRNs rank in the capital structure.”

Repeatable performance

Having already doubled revenues in the past two years, Mr Amine is confident that, subject to market conditions, Credit Suisse can do it again. This is true, he says, even in an increasingly competitive market where there are at least 10 more banks fighting for each mandate than there were four or five years ago.

“Our leveraged finance business is one of the leading businesses in Europe because of the breadth and the balance of the business in terms of both product offerings and client base. That gives us plenty of room for growth, whether it is continuing to build our sponsor business or generating more corporate volumes,” he says. “A number of corporates across Europe have chosen to do bilateral or local country financings rather than international syndicated loans. So to the extent that this opens up to the syndicated finance market, it represents a significant growth opportunity for us.”

Another key trend that Mr Amine says plays directly to Credit Suisse’s strengths is the growing importance of emerging market players, whether corporate or private equity. “Credit Suisse has a solid history and track record in the emerging markets and this is one of our core strengths. For example, we financed Tata Steel’s acquisition of Corus, and have financed most of Orascom’s acquisitions. We were one of the first to focus on providing debt capital to issuers from developing markets, and can build on that business.”

CAREER HISTORY

2007 Sole head of global markets solutions group in Europe at Credit Suisse

2005 Co-head of global markets solutions group in Europe at Credit Suisse First Boston

2004 Co-head of global leveraged finance at Credit Suisse First Boston

1999 Relocated from New York to London to head European leveraged finance at Credit Suisse First Boston

1997 Joined Credit Suisse First Boston in New York in high yield capital

1995 Joined Schroders in leveraged finance

1992 Joined Merrion Group in principal investing

1986 Joined Cravath, Swaine & Moore, specialising in M&A and acquisition financing

Juris Doctor from Harvard University. BA in economics, history and political science from Brown University

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