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.

903.photo.jpg

Jim Amine: “The high-yield investor base is much smaller in Europe”

904.photo.jpg

Hamish Buckland: “In the US, if the price is right you can usually find

a buyer”

905.photo.jpg

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.

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter