Europe’s leveraged finance market is following in the US’s footsteps. However, inherent differences in the bank lending culture, investor base and legal landscapes mean that Europe still lacks the rational pricing of the US market. Joanna Hickey reports.
The US leveraged finance market, comprising the senior debt (leveraged
loan), high-yield and mezzanine markets, is far bigger and deeper than
its European counterpart. In 2002, overall US leveraged volumes
totalled $392.7bn, compared with $75.4bn in Europe. In the 20-year old
US high-yield bond market there has been $81.6bn of issuance in the
year to date, compared with just $12.3bn from Europe’s six-year old
market, according to Thomson Financial.
Size and longevity apart, one of the most fundamental differences
between the two markets is that in Europe the senior debt market is
driven by banks, while in the US, it is driven by institutional
investors. US institutional investors rose to prominence after
consolidation, losses and strategic realignments prevented the bank
market from absorbing the level of supply.
“There are not as many banks in the US. Institutional investors have
filled that capital void and, as they are more sensitive to ratings and
secondary performance, the market dynamics are different,” says Chad
Leat, global head of leveraged finance at Citigroup. The fact that US
institutional investors now account for 75.9% of the US leveraged loan
market (for the 12 months ended June 30), compared with 21.70% in
Europe – according to Standard & Poor’s (S&P) Leveraged
Commentary & Data (LCD) – has shaped the two markets in distinct
ways. Institutional investors price risk to a far tougher standard and
demand higher pricing and more liquidity than banks because they have
to mark-to-market.
Price fluctuations
In the liquid US leveraged loan market, pricing fluctuates in line
with wider market events, relative value and mutual fund inflows, as
well as with specific credit rating and industry sector. When fund
liquidity is strong, borrowers get lower pricing. When liquidity dries
up, spreads rocket and lender-friendly concessions such as Libor floors
appear.
In contrast, Europe’s leveraged loan pricing neither fluctuates in line
with relative value nor, more crucially, differentiates between rating,
market status, industry sector or loan size. Although Europe’s
secondary market is growing as banks realise the importance of
portfolio management and as fund participation rises, many banks still
buy to hold and tolerate lower pricing for relationship reasons.
In the US, average pro rata pricing for a BB-rated credit was 285.3
basis points in the six months ended July 2003, while for a B-rated
credit, pricing was far higher, at 361bp. In Europe, however, pricing
for both BB and B-rated credits in the same period was 225bp, according
to S&P’s LCD, showing no distinction between the different risks.
Such imperviousness has prompted many to label Europe an
unsophisticated backwater, where archaic and irrational pricing
mechanisms still exist. “The lack of pricing differentiation in Europe
is ridiculous,” says David Slade, head of European leveraged loans at
CSFB.
European spreads are also always lower than those in the US, by
30bp-40bp in a bull market and by more than 100bp in a bear market,
while leveraged levels are far higher. Total 2002 US debt to EBITDA was
3.8x compared with 4.2x in Europe, according to S&P’s LCD.
Europe is more credit conscious than the US. “In the US, if the price
is right you can usually find a buyer. But banks in Europe are far more
focused on the credit and leverage and will not do some deals no matter
how high the pricing is,” says Hamish Buckland, co-head of European
leveraged finance at JP Morgan.
Mezzanine fortunes
Another major difference between the two markets is the role of
mezzanine. In Europe, mezz often replaces high-yield in a leveraged
buy-out (LBO) financing. Mezz tranches now total up to E350m ($413m)
and more institutions are raising mezz funds, culminating in Goldman
Sachs’ $2.7bn fund in September – the largest ever.
Meanwhile, US mezzanine takes a back seat to high-yield. “The US mezz
market is generally only used to finance small, higher risk business,
which are not suitable for the public bond market,” says Adam Hewson,
head of European mezzanine at UBS Warburg.
High-yield depth
This is due to the depth of the US high-yield market, which meant
an alternative subordinated debt market has never been needed.
High-yield has a liquidity and pricing advantage that will always be
preferable to the privately placed, more expensive mezz product.
In contrast, Europe’s LBO market was developed without high-yield,
which has been hampered by bad timing. The high-yield market’s
development coincided with the telecom boom and bust, which took many
investors down with it. For several years, high-yield became associated
with telecoms, and mezz was developed as a real alternative to take up
the slack.
Although Europe’s high-yield market is recovering and investors are
returning, sponsors often still prefer the stability of mezzanine.
“The high-yield investor base is much smaller in Europe. There are far
fewer dedicated players, with hedge funds and other fixed income
investors often dipping in and out. Therefore the market is more
volatile and has effectively closed down at times,” says Jim Amine,
head of European leveraged finance at CSFB.
Security issues
Another key distinction between the two markets is that US
high-yield investors have far more security and power in a default
situation than their European counterparts. In Europe, high-yield bonds
have traditionally been structurally subordinated to senior debt and
lack the second secured status that mezzanine enjoys.
In default situations, European bond investors have often lost
everything, as the senior debt lenders drive the bankruptcy
proceedings. US bonds, however, are only contractually subordinated,
are issued at the same level as senior debt and have far greater
security. Again, this has held back the development of European
high-yield.
Despite the fundamental differences in the two markets, some bankers
feel that Europe will evolve into the US model. “Local inventions
eventually become standardised along Wall Street’s blueprint – we’ve
seen this in other areas such as the Eurobond market. Europe is making
progress towards a standardised high-yield product broadly along the
[lines of the] US model. But given the different jurisdictions,
subordination and security issues, this will take time,” says Peter
Combe, co-global head of financial sponsors at Lehman Bros.
There are some indications that this is already happening. This year,
European high-yield investors began refusing to buy structurally
subordinated bonds. As it is in both the sponsors’ and banks’ interests
to develop European high-yield, because bonds are cheaper than mezz and
banks earn far higher fees for arranging them, senior debt lenders are
having to compromise a little. Bondholders are already achieving
slightly improved security, as with the second secured bonds for Brake
Brothers, Safilo and Focus Wickes earlier this year.
In addition, Europe’s secondary loan market is showing the first signs
that it could influence primary pricing, which would lead to a more
rational pricing system. The discussions surrounding the 23.2bn buy-out
of Seat Pagine Gialle’s directories business in September illustrated
that more European lenders are talking about expected secondary
performance when deciding to join a loan in primary. A few banks are
starting to behave more like asset managers than relationship lenders.
Jim Amine: “The high-yield investor base is much smaller in Europe”
Hamish Buckland: “In the US, if the price is right you can usually find
a buyer”
Chad Leat: “Even if Europe’s CDO market continues to grow, banks will be the dominant force”
Differences too entrenched?
However, others say the fundamental differences are too entrenched.
Bank consolidation is unlikely to reach US levels and, although
European collateralised debt obligations (CDOs) are growing, it is
unlikely that Europe will ever have an institutional investor base as
large as the US’s. “Mutual funds dominate the US market. This mutual
fund investor base does not exist in Europe so, even if Europe’s CDO
market continues to grow, banks will still be the dominant force,” says
Mr Leat.
This will impede a more rational loan pricing system – as will fierce
competition among banks for mandates. “Until banks are prepared to lose
a mandate in order to push up pricing, this will continue,” says Mr
Slade.
At the crux of the issue is Europe’s relationship banking culture,
which is preventing both correct loan pricing and the development of
the high-yield market. In the US, corporate high-yield issuance is
extremely high and LBOs are only a fraction of the market, as banks are
less willing to provide leveraged corporates with cheap loans.
Encouraging developments
However, although some encouraging cases such as Heidelberger
Cement, Vivendi and Rhodia have emerged, Europe’s high-yield market is
mainly dominated by LBOs. Banks in Europe still extend cheap loans to
relationship clients to protect their market share and for ancillary
business – which often never materialises or does not compensate for
such loss lending. Many Continental European banks will lend to an LBO
at 225bp but charge a similarly rated domestic corporate at just 150bp.
“One inhibiting factor to more high-yield issuance in Europe is that
European corporates tend to prefer less expensive loans from
relationship banks over accessing the high yield market,” says Tom
Connolly, co-head of credit capital markets at Goldman Sachs.
This is proving endlessly frustrating for the universal and investment
banks that are trying to move European pricing to a more rational
footing and realign corporates’ capital structures with greater
emphasis on high-yield.
Until banks in Europe stop their subsidised lending practices, Europe’s
leveraged finance markets will never achieve their full size and
liquidity potential.
“Banks are still not charging appropriate returns for non-investment
grade corporate loans. These loans need to be priced on a relative
value basis for the secondary market to develop. And the quality of
banks’ portfolios would improve if they stopped providing large cheap
loans to clients that should be recapitalising with a high-yield bond
and loan mix,” says Richard Munn, head of European loan capital markets
at Deutsche Bank.